Let it float: Inflation and states’ priority on monetary independence over exchange rate stability
| Author | Yeon Kyung Grace Park |
| Published date | 01 August 2021 |
| Date | 01 August 2021 |
| DOI | http://doi.org/10.1177/0263395720959994 |
| Subject Matter | Articles |
https://doi.org/10.1177/0263395720959994
Politics
2021, Vol. 41(3) 371 –387
© The Author(s) 2020
Article reuse guidelines:
sagepub.com/journals-permissions
DOI: 10.1177/0263395720959994
journals.sagepub.com/home/pol
Let it float: Inflation and
states’ priority on monetary
independence over exchange
rate stability
Yeon Kyung Grace Park
Boğaziçi University, Turkey
Abstract
Monetary policy autonomy and exchange rate stability are desirable macroeconomic policies
that cannot be attained jointly under internationally mobile capital. In this article, I explore what
happens to state choices between the two policies when a key domestic economic challenge
rises. Among many factors, increasing inflation directly affects citizens’ daily lives through rising
living costs and decreasing purchasing power. Because dissatisfied citizens become more likely to
threaten leaders’ tenure in both democracies and nondemocracies, I argue that leaders will pay
closer attention to domestically oriented citizens’ interest rather than that of internationally/
export-oriented actors when the inflation rate increases. In other words, to effectively tackle
inflation and appease citizens’ discontent, leaders will prioritize their ability to utilize monetary
policy over stable exchange rates that promote international trade and investment. As a result,
states become more likely to relax exchange rates as the inflation rate increases. Interestingly,
empirical results indicate stronger support for hypotheses regarding nondemocratic states.
Keywords
exchange rate regime, international political economy, monetary policy autonomy
Received: 26th February 2020; Revised version received: 25th July 2020; Accepted: 11th August 2020
Introduction
In the post–Bretton Woods era, countries face trade-offs between monetary policy inde-
pendence and stable exchange rates. On the one hand, monetary policy independence
allows states to respond appropriately to domestic economic goals such as growth or price
stability (Broz and Frieden, 2001). However, in this case, states do not make any exchange
rate commitments (Mishkin, 2008). On the other hand, stable exchange rates promote a
state’s investment and trade by reducing uncertainty around international transaction costs.
Nevertheless, states with fixed exchange rates cannot independently direct monetary poli-
cies under internationally mobile capital (Bearce, 2003; Bearce and Hallerberg, 2011;
Corresponding author:
Yeon Kyung Grace Park, Department of Political Science and International Relations, Boğaziçi University,
42423 Istanbul, Turkey.
Email: yeon.park@boun.edu.tr
959994POL0010.1177/0263395720959994PoliticsPark
research-article2020
Article
372 Politics 41(3)
Frieden, 2002; Obstfeld et al., 2005). If a state fixes its exchange rate, the state’s nominal
interest rate should be equal to the world rate in this situation (Fleming, 1962; Mundell,
1960).1 Therefore, when setting macroeconomic policies, a state can have either a stable
exchange rate at the expense of its capacity to use independent monetary policy or mone-
tary policy autonomy that risks a fluctuating exchange rate.
Regarding these two measures that cannot be attained simultaneously, many scholars
have explored what factors affect states’ policy choices. For example, some argue that
developing countries and small economies tend to prioritize stable exchange rates over
monetary policy autonomy. Since a domestic economy is either not stable or dependent
on foreign markets, such states prefer anchoring their exchange rates to a stable one from
more advanced economies to enjoying its ability to manage monetary policies. Another
strand of literature demonstrates that, when facing the two options, rulers whose politi-
cal survival depends on citizens tend to choose monetary policy autonomy (Bearce and
Hallerberg, 2011; Broz, 2002; Leblang, 1999; Steinberg and Malhotra, 2014). A fixed
exchange rate is advantageous to those who are engaged in internationally oriented sec-
tors. While exports and foreign investments are crucial sources of a nation’s economic
growth and revenue, scholars stress that a majority of citizens are engaged in domesti-
cally oriented sectors and prefer monetary policy autonomy to stable exchange rates.
Therefore, despite the preferences of a small export-/internationally oriented interest
group, in a democracy where the public determines the leader’s tenure, the leader is
more likely to prioritize median voters’ interests and choose monetary policy autonomy
over exchange rate stability. Conversely, nondemocratic rulers who channel resources
mostly as private goods to their relatively small coalition of elites tend to choose
exchange rate stability, which can incentivize more investment and trade flows at the
expense of monetary policy tools.
Given that states make choices between these two mutually inconsistent policies, what
happens when there rises an economic challenge? More specifically, how will increasing
inflation affect states’ choices between monetary policy independence and exchange rate
stability? In this article, I argue that states become more likely to relax exchange rates
when inflation increases. For many countries, inflation control is one of the central policy
goals for economic growth and development (Agenor and Taylor, 1993; Bernanke and
Mishkin, 1997; Blackburn and Christensen, 1989; Broz, 2002; Mukherjee and Singer,
2008). Because inflation affects citizens’ daily lives through cost of living, high inflation
makes citizens dissatisfied with the incumbent ruler (Bates, 1981; Jahan and Hossain,
2019; Kim and Gandhi, 2010; Morrisson et al., 1994; Thomson, 2019; Wallace, 2013;
Walton and Seddon, 1994). In the case of democracies, a rising inflation rate will make a
leader pay closer attention to the frustration of domestically oriented median voters.
Therefore, the leader will become more willing to forgo exchange rate stability to inde-
pendently utilize monetary policy, which helps states appropriately respond to external
shocks to the domestic economy (Broz and Frieden, 2001).
Moreover, I argue that rising inflation has the same impact on nondemocratic states.
While a nondemocratic ruler may tend to fix exchange rates to satisfy elite supporters’
preferences, a country’s economic situation affects citizens’ evaluation of their ruler’s
competence even in nondemocracies as many scholars have shown (Ansolabehere et al.,
2014; Chappell Jr, 1990; Escribà-Folch and Wright, 2010; Fiorina, 1981; Guriev and
Treisman, 2020; Healy and Lenz, 2014; Magaloni and Wallace, 2008; Rogoff, 1990).
Among such economic challenges, an increase in the inflation rate imposes greater finan-
cial burdens on citizens than on relatively well-off elites (Broz, 2002; Guisinger and
To continue reading
Request your trial