EFFECTS OF POLITICAL VARIABLES ON CURRENCY CRISIS

Effects of Political Variables on Currency Crisis

Abstract

This study purely highlights the impact of structural political situations on the possibility of currency crises in world's international markets. Controlling for a typical and economical set of macroeconomic variables, this research discover that right-wing administration is less favorable to currency crises. This research could not find a noteworthy impact of elections on the possibility of currency crises.

Table of Contents

CHAPTER 1: INTRODUCTION4

Fundamental Connection between Political Variables and Currency Crises15

Aim of Study18

Hypothesis18

CHAPTER 2: LITERATURE REVIEW23

Sample, Variables and Methodology23

Turkey's Efforts to Attain Macroeconomic Stability30

Models of currency crisis33

CHAPTER 3: THEORETICAL MOTIVATION AND EMPIRICAL STRATEGY35

CHAPTER 4: DATA AND EMPIRICAL STRATEGY42

Data42

Definition of crisis44

Empirical strategy46

Estimation Results50

CHAPTER 5: CONCLUSION57

REFERENCES62

BIBLIOGRAPHY68

APPENDIX A.74

Chapter 1: Introduction

Since the publication of Krugman's seminal (1979) study of currency crises, at least 40 empirical studys on this subject have appeared in scholarly journals. The Asian crisis has stimulated a new wave of such studies. Yet, econometric models built to explain currency crises, in keeping with the predominant theories of speculative attacks, have relied almost exclusively on macroeconomic indicators as explanatory variables. Kaminsky, Lizondo and Reinhart's (Kaminsky et al. 1998, 5-35) extensive review of this literature identifies 60 explanatory variables that have appeared in various models of currency crises, the most commonly used indicators being the real exchange rate, international reserves, real GDP growth and the current account balance. Among those 60 explanatory variables, only four pertain directly to political events.

It is curious, however, that so many studies have relied exclusively on macroeconomic indicators, since, as (Drazen, 2000) notes, decisions to abandon fixed exchange rates may more often reflect a choice among competing policy objectives than a technical incompatibility of monetary and fiscal policy with fixed exchange rates. For instance, (Obstfeld 1994, 189-213) characterizes the government as facing an explicit trade-off between maintaining the fixed exchange rate and other objectives, such as limiting the growth of unemployment. A government's willingness to trade-off inflation for unemployment is inevitably a political decision. Indeed, second-generation currency crisis models typically give rise to the possibility of multiple equilibria in which the realized outcome is a function of market expectations.

This study proposes and tests the hypothesis that market expectations regarding a government's possible response to a speculative attack may be a function of political as well as economic conditions. Despite the considerable elegance of second-generation models in depicting optimal government behavior, such models open the door to political explanations of currency crises, but typically do not cross the threshold. While political factors have played a more central explanatory role in several qualitative studies of crises, particularly in (Dornbusch et al., 1995), the theoretical and empirical literature has been largely silent on the subject. (Drazen, 2000) is among the first to address this gap in theory, though his study concentrates specifically on issue of contagion.

Part of the theoretical motivations for the present analysis lies specifically in combining second-generation currency crisis models (I take (Obstfeld, 1994) as the archtype) with insights from partisan political business cycle theory (Hibbs, 1977 and Alesina, ...