EXCHANGE RATE REGIMES AND FISCAL DISCIPLINE: THE ROLE OF CAPITAL CONTROLS

Abstract

How do exchange rate regimes influence fiscal discipline? This important question has typically been addressed exploiting the classic dichotomy of fixed versus flexible exchange rate regimes assuming perfect capital mobility. However, the role of capital controls cannot be neglected, particularly in developing countries. This paper analyzes the effects of capital controls on fiscal performance by focusing on dual exchange rate regimes. In a model in which the fiscal policy is endogenously determined by a nonbenevolent fiscal authority, dual regimes induce politicians to have higher fiscal deficits than under fixed and flexible regimes operating under perfect capital mobility. The model also shows this effect increases as fiscal authorities become more impatient. Dynamic panel regressions confirm that dual regimes lead to higher fiscal deficits than fixed and flexible regimes operating under unified rates. Using a dummy for pre‐electoral year as an indicator of fiscal authorities' shortsightedness, we also confirm that dual exchange rate has a more adverse effect on fiscal deficits as the authorities become more impatient. (JEL E50, E60, F31, F41)