Coalition Government Formation and Foreign Exchange Markets: Theory and Evidence from Europe

Abstract

This study examines how the politics of coalition government formation affect foreign exchange markets in Western European parliamentary democracies. Existing studies suggest that ex ante uncertainty associated with the formation of coalition governments increases exchange rate volatility. We develop a formal model that places currency traders at the center and examines how traders respond to the uncertainty produced by coalition bargaining in parliamentary democracies. In sharp contrast to the literature, the model shows that traders rationally respond to uncertainty about the potential coalition government that may form and expected policies that will be implemented by the coalition government by reducing the volume of trading they do in that currency and that this, in turn, leads to a decline in the mean and volatility of exchange rates. Estimates from an exchange rate series of 10 Western European parliamentary democracies statistically support the claim that exchange rate volatility is negatively associated with traders' ex ante uncertainty about the potential coalition government that may form.