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The Political Economy of External Discipline: Constraint Versus Incentive Effects of Capital Mobility and Exchange Rate Pegs

  • Thomas D. Willett

    (Claremont McKenna College and Claremont Graduate University)

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    This paper argues that while sources of potential discipline over domestic macro economic policies such as pegged exchange rates, high capital mobility, and IMF policy conditionality are commonly viewed as constraints, it is usually more productive to view them as influencing incentive structures in a world of multiple relevant actors. From this perspective, pegged, as opposed to genuinely fixed exchange rates, are typically not an adequate substitute for domestic discipline enhancing measures. The micro level political economy analysis presented suggests serious limits to the effectiveness of external strategies as sources of discipline. Indeed, their effects can sometimes be perverse. For example, high capital mobility under fixed exchange rates can reduce short run discipline over fiscal policy and impede the ability of an independent central bank to counteract political business cycles in fiscal policy. The analysis highlights the problems of attempting to use commitment devices with asymmetric time profiles to overcome problems generated by the asymmetric short run effects of discretionary monetary and fiscal policies. In particular exchange rate pegging gives front loaded benefits and delayed costs. This makes for a particularly inefficient strategy for trying to avoid domestic macro economic time inconsistency problems. Where short time horizons greatly discount the prospective future costs of a currency crisis, the political incentives generated by pegged rates often fail to provide sufficient monetary and fiscal restraint to avoid such crises. They also tend to discourage the prompt adjustment of disequilibrium exchange rates. As a consequence, exit from a pegged regime is often delayed too long and currency crises result. Thus the political incentive structures generated by exchange rate pegging can be as great a source of difficulty for the smooth operation of intermediate exchange rate regimes as are the economic forces of high capital mobility stressed by many economists. The overall thrust of this paper is to suggest that external sources of discipline over macroeconomic policies are often weak and sometimes perverse. For many, and perhaps most countries, the primary focus for discipline should be internal.

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    Paper provided by Claremont Colleges in its series Claremont Colleges Working Papers with number 2001-29.

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    Date of creation: Aug 2001
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    Handle: RePEc:clm:clmeco:2001-29
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    1. Andrews, David M. & Willett, Thomas D., 1997. "Financial Interdependence and the State: International Monetary Relations at Century's End," International Organization, Cambridge University Press, vol. 51(03), pages 479-511, June.
    2. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
    3. Thomas D. Willett, 2000. "The Need for a Political Economy Capability at the IMF," Claremont Colleges Working Papers 2000-55, Claremont Colleges.
    4. Ernesto H. Stein & Natalia Salazar & Roberto Steiner & Eugenio Díaz-Bonilla & Marco Bonomo & Juan C. Jaramillo & Hector E. Schamis & Alberto Pascó-Front & Piero Ghezzi & Maria Cristina Terra & José De, 2001. "The Currency Game: Exchange Rate Politics in Latin America," IDB Publications (Books), Inter-American Development Bank, number 77398 edited by Ernesto H. Stein & Jeffry Frieden, October.
    5. Thomas D. Willett & Fahim Al-Marhubi, 1994. "Currency Policies for Inflation Control in the Formerly Centrally Planned Economies," The World Economy, Wiley Blackwell, vol. 17(6), pages 795-815, November.
    6. Keefer, Philip & Stasavage, David, 2002. "Checks and Balances, Private Information, and the Credibility of Monetary Commitments," International Organization, Cambridge University Press, vol. 56(04), pages 751-774, September.
    7. Reuven Glick, 2000. "Fixed or floating: is it still possible to manage in the middle?," Pacific Basin Working Paper Series 2000-02, Federal Reserve Bank of San Francisco.
    8. Krugman, P., 1993. "What Do We Need to Know About the International Monetary System?," Princeton Studies in International Economics 190, International Economics Section, Departement of Economics Princeton University,.
    9. Willett, Thomas D. & Keil, Manfred W. & Ahn, Young Seok, 2002. "Capital mobility for developing countries may not be so high," Journal of Development Economics, Elsevier, vol. 68(2), pages 421-434, August.
    10. Alesina, Alberto F & Cohen, Gerald D & Roubini, Nouriel, 1992. "Macroeconomic Policy and Elections in OECD Democracies," CEPR Discussion Papers 608, C.E.P.R. Discussion Papers.
    11. David Romer, 1991. "Openness and Inflation: Theory and Evidence," NBER Working Papers 3936, National Bureau of Economic Research, Inc.
    12. Bird, Graham, 1996. "The International Monetary Fund and developing countries: a review of the evidence and policy options," International Organization, Cambridge University Press, vol. 50(03), pages 477-511, June.
    13. Giavazzi, Francesco & Pagano, Marco, 1986. "The Advantages of Tying One's Hands: EMS Discipline and Central Bank Credibility," CEPR Discussion Papers 135, C.E.P.R. Discussion Papers.
    14. Robert H. Bates & Avner Greif & Margaret Levi & Jean-Laurent Rosenthal, 1998. "Analytic Narratives," Economics Books, Princeton University Press, edition 1, volume 1, number 6355.
    15. Bayoumi, Tamim & Eichengreen, Barry, 1998. "Exchange rate volatility and intervention: implications of the theory of optimum currency areas," Journal of International Economics, Elsevier, vol. 45(2), pages 191-209, August.
    16. Clark, William Roberts & Reichert, Usha Nair & Lomas, Sandra Lynn & Parker, Kevin L., 1998. "International and Domestic Constraints on Political Business Cycles in OECD Economies," International Organization, Cambridge University Press, vol. 52(01), pages 87-120, December.
    17. Barry J. Eichengreen & Inci Ötker & A. Javier Hamann & Esteban Jadresic & R. B. Johnston & Hugh Bredenkamp & Paul R. Masson, 1998. "Exit Strategies; Policy Options for Countries Seeking Exchange Rate Flexibility," IMF Occasional Papers 168, International Monetary Fund.
    18. repec:idb:brikps:77398 is not listed on IDEAS
    19. Chan Huh, 1997. "Inflation targeting," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue feb7.
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