The Effect of Government Ideology on an Exchange Rate Regime: Some International Evidence

• Date: 01 April 2017
• Published date: 01 April 2017
• Author: Chien‐Chiang Lee,Chun‐Ping Chang
• DOI: http://doi.org/10.1111/twec.12018

The Effect of Government Ideology on an

Exchange Rate Regime: Some

International Evidence

Chun-Ping Chang

1

and Chien-Chiang Lee

2

1

Department of Marketing Management, Shih Chien University at Kaohsiung, Taiwan and

2

Department

of Finance, National Sun Yat-sen University, Kaohsiung, Taiwan

1. INTRODUCTION

EXCHANGE rate regime determination has receive d noteworthy academic research and dis-

cussions in the past decade, providing the essential consequences for price stability, interna-

tional trade and monetary policy (Frieden et al., 2010). Rose (2011) states that a country usually

determines regime selection in relation to its national characteristics. Countries with a large

volume of trading in foreign exchange markets and more persistent long-run regime durability

are closely linked to a fixed exchange rate regime, whereas small countries do not have floating

currencies. Evidence also shows that the choice of exchange rate regime and the desired level

of the exchange rate involve distributionally relevant tradeoffs at the national level. Doubtlessly,

these choices will combine into significant economic and political implications (Broz and Frie-

den, 2001). In particular, scholars strongly support that political–economic factors are powerful

predictors of exchange rate regime selection, yet studies are still comparatively rare for the topic

of the role of government ideology. We expand upon the literature by incorporating a wider and

deeper array of the incumbent party’s ideology considerations.

Previous literature provides extensive evidence that political parties have different prefer-

ences in regard to macroeconomic objectives (Hibbs, 1977; Alesina, 1987). For example,

right-wing governments that advance economic freedom favour the protection of property

rights and legal quality and promote minimum government involvement in the economy,

while left-wing governments prefer government intervention in the economy (Bjørnskov,

2005).

1

Following this line, government ideological differences across political parties create

diverse attitudes in regard to policy and in turn may play a critically important role in

We would like to thank the Editor, Professor Zhihong Yu and the three anonymous referees for their valu-

able comments, which have led to a substantial improvement in the original paper. Chun-Ping Chang is

grateful to the National Science Council of Taiwan for financial support through grant NSC 100-2410-H-

158-003.

1

The theoretical study of Milesi-Ferretti (1995) also illustrates that a right-wing government may abstain

from choosing a fixed exchange rate regime with the intention of benefiting from the inflationary reputation

policies of a left-wing government. Thus, a left-wing party has greater inducements to choose a fixed

exchange rate regime, because it experiences greater credibility problems, as opposed to a right-wing party.

However, Milesi-Ferretti (1995) assumes that exchange rates are fixed forever. Bodea (2010) deviates from

the assumption that exchange rates are fixed forever and maintains that left-wing governments realign fixed

exchange rates moderately less, while right-wing governments are typically more inclined to realign fixed

exchange rates and attempt to circumvent realignments, because of previous high rates of inflation.

The World Economy (2017)

doi: 10.1111/twec.12018

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The World Economy

determining the choice of exchange rate regime. For instance, when right-wing governments

are assumed to favour low inflation, they may choose a fixed exchange rate regime to create

monetary stability, which in turn generates low rates of inflation (Broz and Frieden, 2001).

However, left-wing governments are assumed to have a preference for relatively low unem-

ployment and high output, and they thus may favour a flexible exchange rate regime to man-

age independent monetary policy (Frieden et al., 2010). In a similar notion, according to Broz

and Frieden (2001), a flexible exchange rate regime permits the government to regulate the

nominal exchange rate to assure competitiveness in the tradable sector.

2

When market-oriented and right-wing parties are inclined to favour economic freedom and

prefer minimum government involvement in the economy, other phenomena are noticed. The

empirical works of Potrafke (2010) and Bjørnskov and Potrafke (2011) demonstrate that mar-

ket-oriented and right-wing governments promote and advance privatisation, liberalisation and

deregulation processes. As such, right-wing governments might be sufficiently pro-market to

allow the market to set the exchange rate. More explicitly, a left-wing government that imple-

ments a flexible regime has smaller credibility gains (Broz and Frieden, 2001). It is also pos-

sible that a left-wing government may approve market-oriented policies when challenged with

the reality that such reforms are necessary, credibly convincing the public of the importance

of these changes (Cukierman and Tommasi, 1998). Thus, under these conditions, a left-wing

government may be able to credibly commit to a fixed exchange rate regime. According to

these arguments, the ideological connection to the exchange rate choice is far from clear, and

we hope that we can bring a definite solution through our empirical works herein.

It is worthwhile to note that the choice of exchange rate regimes also include the selection

of pegs or managed floating arrangements, which are classified as intermediate regimes. That

said, when most national governments commonly decide whether to fix their currency or to

allow it to float, these governments may face more immediate choices, such as whether to

defend or devalue the currency when under an external attack or for the purpose of promoting

monetary policy (Broz and Frieden, 2001). At such a time, a regime that is managed fixed,

has limited flexibility or is more flexible will be selected. In other words, restricted by two

possible options – pure floating and fixed regimes – such classification is unable to meet the

needs of a government for the exchange rate regime choice. In fact, in Ilzetzki et al.’s (2008)

and International Monetary Fund (IMF) classifications, there are 15 regimes that run from ‘no

separate legal tend’ to ‘dual market in which parallel market data are missing’. Policymakers

also confront choices related to different levels of the exchange rate between the two

extremes, in which case the exchange rate behave like it is actively managed.

Our work provides several contributions to the existing literature. First, we go beyond

using different exchange rate regime classifications – such as the de facto classification in

Shambaugh (2004; hereafter Shambaugh), Levy-Yeyati and Sturzenegger (2005), and Ilzetzki

et al. (2008; hereafter IRR) and the de jure IMF course classification (hereafter IMF), which

is also set up by Ilzetzki et al. (2008) – as the dependent variable, by estimating an empirical

model of government ideology on the exchange rate regime choice using panel data encom-

passing 147 countries (listed in Table A1) and data that span from 1974 to 2004 (when the

classification is Shambaugh or LYS) or data from 1974 to 2009 (when the classification is

IRR or IMF). Second, we employ both multinomial logit (MNL) and multinomial probit

(MNP) models as the principle techniques to identify the actual role of government ideology

2

Frieden et al. (2010) emphasises that tradable producers favour a floating exchange rate regime, thus

permitting an exchange rate policy to influence competiveness in the tradable sector.

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GOVERNMENT IDEOLOGY ON AN EXCHANGE RATE REGIME 789

in determining specific regime choices, since the estimated coefficients from these models

allow us to disentangle the relative probability of a government’s likelihood over its choice of

a different exchange rate regime.

Except for the ideology variable, we also study several channels that link politics and insti-

tutions to the choice of the exchange rate regime, including number of seats held in the legis-

lative body by the government party, the tenure of the government in office, the level of

democracy, central bank independence and electoral influence. Other contributions focusing

on economic dimensions, such as globalisation, real GDP per capita, inflation and interna-

tional reserves, are more closely related to the macroeconomic policy stance and to the choice

of the exchange rate regime. Fourth, we separate our sample countries into Organisation for

Economic Cooperation and Development (OECD) countries versus non-OECD countries as

well as Eurozone countries versus non-Eurozone countries to examine the choice of exchange

rate regime determination. To our knowledge, this paper is the first systematic and compre-

hensive assessments of the role played by government ideology in exchange rate regime

choice. It is expected that the empirical results will lead to different policy implications for

countries in the different groupings. Fifth and finally, we conduct a panel ordered logistic

regression with robust investigations for all empirical specifications.

Given the implications of an exchange rate regime, it is critically important to understand

what determines the type of exchange rate regime. In reviewing the literature on exchange

rate regime determinations, we discover that government ideology, political institution , globa-

lisation and macroeconomic variables impact the choice of exchange rate regime. Particularly,

empirical results match our anticipation and present a consistent view. A left-wing govern-

ment is more likely to implement a ‘flexible’ regime in the full samples, but evidence is

weaker when using the IMF course classification as the explained variable. We hence achieve

a broad similar finding in the OECD and Eurozone cases, whereby government ideology

seems to have a clearer impact on actual (de facto) exchange rate regimes than the officially

declared (de jure) ones, meaning that partisan ideology only shows its influences on an

exchange rate already de facto implemented, but not on those levels that are de jure

announced. When all empirical processes are verified again by MNP models, the resu lts

are broadly consistent with MNL’s analysis. All our results are robust to the panel ordered

logistic model.

The rest of the paper is organised as follows. Section 2 is the literature review. Section 3

introduces the empirical models of MNL and MNP. Section 4 describes the data, the variables

utilised in the analysis, the empirical results for the baseline specification and the OECD ver-

sus non-OECD countries as well as the Eurozone versus non-Eurozone countries. Section 5

discusses the results from a sensitivity analysis based on the panel ordered logistic regres-

sions. The final section summarises the major findings.

2. LITERATURE REVIEW

Given that political parties have systematically different preferences in regard to macroeco-

nomic objectives, a large strand of literature has made considerable progress in providing evi-

dence that political parties differ in their valuation of macroeconomic intentions. This

fundamental view dates back to the prominent work of Hibbs (1977), who emphasises that

right-wing and left-wing governments differ in their preferences regarding output growth,

employment and price stability. In this context, Alesina (1987) argues that left-wing parties

are more averse to unemployment and less averse to inflation than right-wing parties. Potrafke

Ó2013 Blackwell Publishing Ltd.

790 C.-P. CHANG AND C.-C. LEE