Political Pressures and Exchange Rate Stability in Emerging Market Economies

This paper presents a political economy model of exchange rate policy. The theory is based

on a common agency approach with rational expectations. Financial and exporter lobbies exert

political pressures to influence the government's choice of exchange rate policy, before shocks

to the economy are realized. The model shows that political pressures a¤ect exchange rate

policy and create an over-commitment to exchange rate stability. This helps to rationalize the

empirical evidence on fear of large currency swings that characterizes exchange rate policy of

many emerging market economies. Moreover, the model suggests that the e¤ects of political

pressures on the exchange rate are lower if the quality of institutions is higher. Empirical

evidence for a large sample of emerging market economies is consistent with these …ndings.