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During the last few years there has been an increasing interest in understanding the relationship between exchange-rate regimes and macroeconomic stability. Some recurrent policy questions are: (a) why do countries still choose fixed, nominal exchange-rate regimes 25 years after the abandonment of the Bretton Woods system? (b) do fixed exchange-rate regimes impose an effective constraint on monetary and fiscal behavior, thus lowering inflation rates over the long run? and (c) are exchangerate-based stabilization programs superior to money-based programs? This paper deals with the first question-the selection of the exchange-rate regime-from a politicaleconomy perspective. Why certain countries choose a particular type of exchange-rate regime is a highly relevant question. Why does Austria have a fixed exchange rate, for example, while the United Kingdom has a flexible one? Why has Argentina chosen a fixed exchange rate, while Chile has a flexible-cumbands system? More generally, in December 1992, why did 84 countries (out of the 167 reported in the IMF's International Financial Statistics) peg their currencies to a major currency or a currency composite? The theoretical discussion deals with the trade-off between credibility and flexibility, and it emphasizes the role of politics and institutions. In the empirical section I use a large cross-country panel data set to analyze the role of various factors, including political instability, in deciding whether a pegged or a flexible exchangerate system will be chosen.
I. The Political Economy of Exchange-Rate Regimes
Consider the case of a two-period economy where the authorities' preferences are quadratic and depend on a nominal variable (inflation) and on deviations of a real variable (unemployment) from their target. The authorities choose between a pegged or a flexible exchange-rate system. In making this decision the authorities face an important trade-off: namely, under a pegged exchange rate inflation will be lower, but the deviation from a given unemployment target will be higher than under flexible rates.
The authorities also consider a positive probability (q) of abandoning the parity under a pegged regime. In other words, the authorities fix the exchange rate during the first period, but an "escape clause" can be exercised at the beginning of the second period. When the pegged rate is abandoned, the country adopts a flexible rate, but the authorities incur a political cost ( C) ....