The political economy of exchange rates fluctuations

The objective of this study is to ascertain how politics affect exchange rate misalignments. This is especially important for economic development because exchange rates affect international competitiveness and also impact on economic growth by affecting the allocation of resources. Maintaining a misaligned exchange rate sends the wrong message to economic agents, affects the credibility of governments and results in welfare losses. Therefore, governments try to avoid the harmful consequences of misalignments, especially recurrent devaluations.; Economists have established that a large portion of the long-term variation in exchange rates is due to economic pressures, but exchange rates are also a good barometer of the domestic politics. Effective governments foster trust in their capacity to manage and implement policies to avoid misalignments. Human and material resources are the key to governments' performance. Two variables constitute political capacity: political penetration and relative extraction. Political penetration of a society reflects the ability of the elites to reach and mobilize the population. Relative extraction refers to the success of governments, at similar levels of development, in extracting material resources to advance their goals.; Using pooled-time series analysis for 90 countries for 1960 through 1985, I find that politically capable governments are able to manipulate the real exchange rate avoiding deterioration of their economic structures. These effects are stronger under the flexible exchange regime, where governments have more room to manoeuver than under the fixed exchange regime. But, politics is felt most when the currency is highly devalued. Also, the more restrictions the government tries to impose on the exchange market, the more their real exchange rate tends to depreciate and the more political capacity is needed to control the exchange market.; Weak governments could affect exchange rates most effectively, but their weakness prevents them from doing so. Effective governments are at the mercy of economic forces. The implications are important because political interventions are most effective when applied by weak governments and least effective when applied by capable governments.