REAL EXCHANGE RATE CYCLES AROUND ELECTIONS

Abstract

We develop the implications of devaluation cycles for real exchange rates in a two-sector small open economy with a cash-in-advance constraint. Policy-makers are office-motivated politicians. Voters have incomplete information on the competence and the opportunism of incumbents. Devaluation acts like a tax, and is politically costly because it can signal the government is incompetent. This provides incumbents an incentive to postpone devaluations, and can lead to an overvalued exchange rate before elections. We compare the implied cycle of appreciated/depreciated exchange rates with empirical evidence around elections from Latin America. THIS PAPER explores the behavior of real exchange rates around elections, in a model in which politicians are office-motivated. We show that politicians are often tempted to provoke real exchange rate cycles around elections, delaying depreciations until after elections have taken place. In addition, we present evidence on electoral cycles in real exchange rates in Latin America, which is consistent with the implications of the model. Unlike early opportunistic models on political cycles, such as Nordhaus (1975) and Lindbeck (1976) that assumed voters were myopic, here voters have asymmetric information regarding the competency of the incumbent. In this, our treatment of political budget cycles (PBCs) follows Rogoff and Sibert (1988) and Rogoff (1990), where cycles are the result of a signaling game between incumbents and forward-looking rational voters. In our model, voters are also assumed to have asymmetric information regarding the opportunism of politicians, although this second dimension of asymmetric information is not necessary to obtain budget cycles. 1 To study the behavior of the real exchange rate, we extend the Stein and Streb (2004) one-sector model, where incumbents have an incentive to lower the nominal rate of depreciation before elections to enhance their reputation of competency, to a two-sector model with tradable and non��