Political Booms, Currency Crises and Economic Growth

Abstract

Popularity-concerned governments may not have enough incentives to take decisive corrective actions to address underlying weaknesses in the economy, since such prudent policies, that would be optimal for the economy, may be politically costly in the short-term. This approach, in turn, can deteriorate economic fundamentals and increase related risks in the economy which can eventually lead to crises. I show evidence on this phenomenon in the case of currency crises. I find that political booms, defined as the rise in governments` popularity, are a good predictor of currency crises, suggesting that currency crises are often ``political booms gone bust'' events. However, higher international reserves, higher exports, and a higher degree of financial openness alleviate the effect of political booms on currency crises.