The political economy of exchange rate regimes in developed anddeveloping countries

Aziz N. Berdiev a, Yoonbai Kim b, Chun Ping Chang c,⁎a Department of Economics, Bryant University, Smithfield, RI 02917, USAb Department of Economics, University of Kentucky, Lexington, KY 40506, USAc Department of Marketing Management, Shih Chien University at Kaohsiung, Kaohsiung, Taiwan

a r t i c l e i n f o a b s t r a c t

Article history:Received 26 October 2010Received in revised form 16 June 2011Accepted 18 June 2011Available online 25 June 2011

This paper examines the influence of government ideology, political institutions andglobalization on the choice of exchange rate regime via panel multinomial logit approachusing annual data over the period of 1974–2004 in a panel of 180 countries: 26 developed and154 developing.We provide evidence that government ideology, political institutions and globalization areimportant determinants of the choice of exchange rate regime. In particular, we find that left-wing governments, democratic institutions, central bank independence and financialdevelopment increase the likelihood of choosing a flexible regime, whereas more globalizedcountries have a higher probability of implementing a fixed regime. More importantly, we findthat political economy factors have different effects on the choice of exchange rate regime indeveloped and developing countries. All our results are robust to panel ordered probit model.

© 2011 Elsevier B.V. All rights reserved.

JEL classifications:F6H8

Keywords:Political economyExchange rate regimesPanel multinomial logit model

1. Introduction

The economic and political science literature emphasizes that political parties promote and advance policies in conformitywiththeir ideology (Hibbs, 1977). Pearce (2006) explains that “governments may begin with an ideology and part of that ideologytranslates into policy proposals (p. 155).” In this context, political parties favor the “inherent effects of their policies and thatparties have different objectives and incentives (Alesina, 1987:652).” The influential work of Hibbs (1977) first documented thatleft-wing governments favor relatively low unemployment, and, in turn, tolerate high rates of inflation in order to maintain lowrates of unemployment. In contrast, right-wing governments prefer moderately low inflation at the expense of high rates ofunemployment. In this line, left-wing parties are more averse to unemployment and less averse to inflation than the right-wingparties (Alesina, 1987). Thus, a large strand of literature has been devoted into understanding the nature and significance ofgovernment ideology in economic policy.

The principal role of government in the economy is an underlying discord between right-wing and left-wing parties(Potrafke, 2010a). Right-wing governments favor protection of property rights and legal quality, while left-wing governmentsprefer government intervention in the economy (Bjørnskov, 2005a). Several papers, including the works of Bortolotti et al.(2003) and Potrafke (2010a), for example, explain that right-wing governments are associated with the privatization andderegulation processes to expand the support for market-oriented reforms.1 More explicitly, market-oriented and right-wingparties promote economic freedom and prefer minimum government involvement in the economy. The empirical works of

European Journal of Political Economy 28 (2012) 38–53

⁎ Corresponding author. Tel.: +886 7 6678888 5713; fax: +886 7 6679999.E-mail address: cpchang@mail3.kh.usc.edu.tw (C.P. Chang).

1 Benoit and Laver (2006) indicate that right-wing parties approve significantly more policies on deregulation, compared to left-wing governments.

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Duso (2002), Pitlik (2008), Bortolotti and Pinotti (2008), Bjørnskov and Potrafke (2011) and Potrafke (2010a) demonstratethat market-oriented and right-wing governments promote and advance privatization, liberalization and deregulationprocesses.

Recently, exchange rate regime determination has received noteworthy academic research and discussion. The type ofexchange rate regime provides essential consequences for price stability, international trade and monetary policy (Frieden et al.,2010). Thus, an extensive literature provides considerable evidence that government ideology influences the exchange ratepolicies. More precisely, government ideological differences across political parties create diverse attitudes in regards to policy,and, in turn, play a critically important role in determining the choice of exchange rate regime. For instance, when right-winggovernments are assumed to favor low inflation, theymay choose fixed exchange rate regime in order to createmonetary stability;and, in turn, generate low rates of inflation (Frieden and Stein, 2001; Broz and Frieden, 2001; Levy-Yeyati et al., 2010; Frieden et al.,2010). In a similar notion, when left-wing governments are assumed to prefer relatively low unemployment and high output, theymay favor the flexible exchange rate regime to manage independent monetary policy in order to achieve its macroeconomicobjectives (Broz and Frieden, 2001; Frieden et al., 2010).

In addition, the theoretical consideration of Milesi-Ferretti (1995) illustrates that a right-wing government may abstain fromchoosing a fixed exchange rate regime with the intention of benefiting from inflationary reputation policies of the left-winggovernment. Bodea (2010), who expands on the work of Milesi-Ferretti (1995), suggests that right-wing governments aretypically more inclined to realign fixed exchange rates. The fundamental argument is that market-oriented governments (right-wing) favor the fixed exchange rate regime in the choice of exchange rate system, while the intervened-oriented governments(left-wing) prefer a flexible exchange rate regime. Yet, Klein and Schambaugh (2010) emphasize that the proposition that right-wing parties advance and promote the fixed exchange rate regime is not supported by many empirical studies, and, therefore,generated mixed results.

Despite the great deal of academic research and discussion, the influence of government ideology on exchange rate regimechoice is not straightforward, and empirical studies often produce contradictory findings.2 Earlier empirical literature hasgenerated inconsistent results regarding the effect of ideology on the exchange rate regime, which we believe are obscured by thevarious econometric techniques, the choice of explanatory variables that impact exchange rate regime determination and furthermitigating factors such as the linkage of exchange rate regime choice to other policies. Hence, the goal of the present paper is toexamine the impact of government ideology, political institutions and globalization on the choice of exchange rate regime acountry implements.

The present paper contributes to the existing literature on the effects of government ideology, political institutions andglobalization on the choice of exchange rate regime along several dimensions. First, we ask, does government ideology influencethe choice of exchange rate regime? A review of the literature suggests that governments prefer a fixed exchange rate regime tocreate monetary stability, which is generally associated with low rates of inflation (Frieden and Stein, 2001; Broz and Frieden,2001; Levy-Yeyati et al., 2010; Frieden et al., 2010). Alternatively, the foremost benefit of a flexible exchange rate regime is toallow the government to conduct independent monetary policy (Broz and Frieden, 2001). Given that policymakers havesystematically different preferences regardingmacroeconomic objectives and differ in their valuation of growth, employment andprice stability, policymakers may choose the exchange rate regime that conforms to their political orientation. In the interest ofrobustness, we use three measures of government ideology in our empirical analysis. In particular, we follow the methodology inDreher et al. (2010) and Bjørnskov (2005b, 2008) by employing the national election results characterized in the Beck et al. (2001)Database of Political Institutions, which classifies the three largest government parties according to whether they have a left-wing,centrist or right-wing ideological orientation.

Second, we examine the impact of political institutions, central bank independence and electoral motives on the type ofexchange rate regime a country implements. While government ideology is one factor that can influence the choice of exchangerate policy, it may also be the case that political institutions impact the exchange rate regime determination.3 For example,democratic institutions facilitate greater information and render credible signal about policy objectives to the public than non-democracies (Fearon, 1994; Broz, 2002). Perhaps not surprisingly, politicians in democratic institutions incur demands to employmore redistributive policies than politicians in authoritarian countries (Leblang, 1999). As such, democratic institutions mayimplement a flexible exchange rate regime in order to allow the government to conduct monetary policy toward domesticstabilization purposes.

Further, the work of Pissarides (1980) explains that governments may potentially strive to control the economy to make thema more “popular party.” In a similar notion, Bernhard and Leblang (1999) emphasize that policymakers are disinclined torelinquish any policy instruments that can facilitate them in gaining office. That is, policymakers may influence the exchange rateregime before the elections to facilitate output growth in order to increase their probability of reelection. Thus, prior to elections,policymakers may choose the flexible exchange rate regime to allow the government to conduct monetary policy to achieveemployment growth to facilitate their likelihood of reelection. Nevertheless, a credible independent central bank predictably hasthe ability to oppose pressures from policymakers (Klein and Schambaugh, 2010). That is, a high level of central bankindependence considerably constrains the authority of policymakers to guide monetary policy for electoral intentions (Clark et al.,1998). The purpose for appointing monetary policy to a credible independent central bank is to eliminate political conflict over

2 For a detailed literature review, see Broz and Frieden (2001).3 We construct our discussion on democracies and nondemocracies in the analysis of domestic political institutions. A similar body of research has examined

the effect of political strength on the choice of exchange rate regime (Frieden and Stein, 2001; Hossain, 2009; Levy-Yeyati et al., 2010).

39A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

monetary policy decisions (Crowe, 2008). In addition, central bank independence combined with a flexible exchange rate regimedelegates the accountability for monetary policy decisions exclusively to the central bank in order to promote policyindependently without government intervention (Siklos, 2008).

Third, we investigate the influence of globalization on the choice of exchange rate regime. The process of globalization, whichintegrates the world economy into a single system, may also affect the choice of exchange rate policy.4 We follow the work ofMcKinnon (1963), who emphasized that “openness” is an essential factor that influences the choice of exchange rate regime acountry implements. More recently, Frieden (2008) argues that the process of globalization intensifies the importance of theexchange rate regime. Many countries have attempted to facilitate economic integration via trade agreements to liberalizecommercial flows through reduction in tariffs. Concurrently, advancement in technology is facilitating improvement in the flowsof information and of goods and services. These movements are promoting the stability and growth of an economy by creatinggreater efficiency in coordination and reducing the costs of transaction and transportation. In this regard, international capitalmobility and global integration has challenged the ability of governments to enact national policy. Hence, open economies, whichare globally integrated countries, may favor exchange rate policy that reduces risks associated with exchange rate variability thatcould potentially deter international trade and investment.

Finally, we explore the choice of exchange rate regime determination in an unbalanced panel of 180 countries: 26 developedand 154 developing. We uncover several interesting differences in the choice of exchange rate regime in developed anddeveloping countries. We also integrate further explanatory variables for efficient estimations results. More specifically, weincorporate explanatory variables such as the level of financial and economic development, inflation and lending interest rates.Weexamine the determinants of exchange rate regime via panel multinomial logit approach with fixed-effects model, wherecountries are allowed to choose among the exchange rate regimes. We employ panel data analysis to account for the presence ofheterogeneity in the estimated parameters and dynamics across countries (Baltagi, 1995). The analysis is based upon datarecorded annually over the period of 1974–2004. We utilize the de facto classification of exchange rate regime, developed andconstructed by Levy-Yeyati and Sturzenegger (2005), which represents the actual classification of exchange rate regime ratherthan announced policies. We also estimate ordered probit model to further support the robustness of our results.

Overall, we provide robust evidence that government ideology, political institutions and globalization are importantdeterminants of the choice of exchange rate regime. In particular, we find that a left-wing government is more likely to adopt aflexible regime and less likely to implement a fixed regime. Further, we provide evidence that democratic institutions have ahigher probability of choosing a flexible regime. Similarly, we also discover that politicians have a higher probability of choosing aflexible regime prior to elections. Also, central bank independence is associated with a flexible regime. More globalized countriesare more likely to choose a fixed regime and no significant effect on choosing a flexible regime.

More importantly, we find that political economy factors have different effects on the choice of exchange rate regime indeveloped and developing countries. In particular, we display that a left-wing government is more likely to choose a flexibleregime in developing countries, however, no significant effect of choosing a flexible regime in developed countries. Also, ourfindings suggest that more globalized countries in developed economies favor a fixed regime, whereas developing economiesprefer a flexible regime. Further, greater financial development in developed countries increases the probability of a flexibleregime, though developing countries are more likely to choose a fixed regime.

The remainder of the paper is structured as follows. In Section 2, we discuss the determinants of exchange rate regime inaccordance with the previous literature. Section 3 details the econometric methodology employed in the investigation anddescribes the data. Section 4 presents the empirical results. The final section summarizes the major findings.

2. Determinants of exchange rate regimes

Previous literature has emphasized that right-wing and left-wing governments differ in their preferences regarding output,employment and price stability: right-wing governments favor moderately low rates of inflation, whereas left-wing governmentsprefer relatively low unemployment (Hibbs, 1977; Alesina, 1987). In this context, governments favor a fixed regime to generatemonetary stability, which is generally associated with low rates of inflation (Frieden and Stein, 2001; Broz and Frieden, 2001;Levy-Yeyati et al., 2010; Frieden et al., 2010). This effect transpires via two channels: fixed exchange rates (1) create obstacles forthe prices in the tradable sector to increase without attracting rival imports, and (2) function as a strong signal of governmentobjectives, as politicians “tie their own hands as a commitment device (Frieden and Stein, 2001:3).” On the latter channel,policymakers implement a fixed regime to signal their commitment to price stability and convincingly reveal to the public thattheir hands are tied (Eichengreen and Leblang, 2003; Frieden et al., 2010).5

Further, governments who favor low inflation may choose a fixed regime with the purpose of eliminating monetary policy(Frieden et al., 2010). Governmentsmust, on the other hand, relinquish their ability to conduct an independentmonetary policy bychoosing the fixed exchange rate regime (Broz and Frieden, 2001).6 As a result, an economy with international capital mobility

4 Petras and Veltmeyer (2001) explain that globalization represents the process of “widening and deepening of the international flows of trade, capital,technology and information within a single integrated market (p. 11).”

5 Levy-Yeyati et al. (2010) also explains that governments experiencing difficulties of persuading the public of their promise to price stability may use a fixedregime to reduce uncertainty and contain inflationary anticipations.

6 The principle of the “impossible trinity” suggests that a fixed regime and independent monetary policy are not concurrently achievable in the presence ofcapital mobility.

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that chooses a fixed regime causes monetary policy to be ineffective. However, attaining monetary stability is a considerableadvantage for governments with a preference for price stability. Thus, when the right-wing governments are assumed to favor lowinflation, they may choose a fixed regime in order to create monetary stability, and, in turn, generate price stability.

Alternatively, the fundamental benefit of a flexible regime is to allow the government to conduct its own independentmonetary policy (Broz and Frieden, 2001). Monetary policy has significant influence on the level of employment and incomebecause it stimulates capital outflow, depreciate the real exchange rate and generates trade surplus (Mundell, 1963). For example,high levels of capital flows could potentially appreciate the real exchange rate, generating a shift of resource allocation from thetradable to the nontradable sector of the economy. Thus, a large influx of capital may generate movement of resources – labor andproduction – from the tradable to the nontradable sector of the economy, deteriorating the international competitiveness of aneconomy (Edwards, 1998). A flexible regime permits the government to regulate the nominal exchange rate to assure thecompetitiveness in the tradable sector (Broz and Frieden, 2001). In this line, when the left-wing governments prefer relatively lowunemployment and high output, they may favor a flexible regime to manage independent monetary policy.

However, a left-wing government that implements a flexible regime has smaller credibility gains (Broz and Frieden, 2001).Therefore, it is likely that a left-wing government may choose a fixed regime because it experiences greater credibility problems(Milesi-Ferretti, 1995; Bodea, 2010). It is also important to note that the choice of exchange rate regime influences fiscal policy(Markiewicz, 2006). For example, according to the Mundell–Fleming model, a small open economy with relatively free capitalmobility that chooses a fixed regime generates greater independence to conduct fiscal policy. Nevertheless, a fixed regimecommands that the government counter to exogenous shocks and entails that fiscal policy be under control (Frieden and Stein,2001).7 When the economy experiences an unfavorable disturbance, such as a movement in international demand away from thegoods it produces, monetary policy becomes ineffective (Frankel and Rose, 1996). Hence, countries may potentially experienceunwarranted welfare losses in employment and output without the ability to employ monetary policy to neutralize localizedeconomic shocks (Bernhard and Leblang, 1999). However, it is also possible that a left-wing government may approve market-oriented policies, when challenged with the reality that such reforms are necessary, and credibly convince the public of theimportance of these changes (Cukierman and Tommasi, 1998). Thus, under these conditions, a left-wing government maypotentially be able to credibly commit to a fixed regime.

The configuration of domestic political institution also has significant influence on the type of exchange rate regime a countrychooses (Bernhard and Leblang, 1999; Hossain, 2009; Frieden et al., 2010). Democratic institutions facilitate greater information andrender credible signal about policy objectives to the public than nondemocracies (Fearon, 1994; Broz, 2002). Hence, governments indemocratic institutions face pressures for expansionarymonetary policy, and experience higher domestic political costs.8 In this line,democratic institutions are more likely to implement a flexible regime to allow the government to conduct monetary policy towarddomestic stabilizationpurposes (Leblang, 1999). Broz (2002) argues that democracies declare aflexible regime, provided that they aremore transparent and politically accountable institutions.9 In a similar notion, Frieden and Stein (2001) explain that dictatorship andauthoritarian countries are more likely to employ the necessary instruments to sustain a fixed regime.10

The political business cycle literature emphasizes that policymakers may use the exchange rate regime to achieve short-termmacroeconomic objectives prior to elections (Clark et al., 1998; Bernhard and Leblang, 1999; Carmignani et al., 2008; Hossain,2009). Prior to elections, it is challenging for governments to maintain a fixed regime due to pressures toward greaterexpansionary policy (Carmignani et al., 2008). That is, policymakers are disinclined to relinquish any policy instruments that canfacilitate them in gaining office (Bernhard and Leblang, 1999). Pissarides (1980) argues that voters increase their support forpolicymakers if they are successful in pursuit of price stability and employment growth. Thus, when elections approach,policymakers may choose the flexible regime to allow the government to manage independent monetary policy to realize short-term output growth and low rates of unemployment with the intention of winning the election (Hossain, 2009).

Nevertheless, policymakers cannot utilize macroeconomic conditions for electoral intentions when monetary policy is underthe control of an independent central bank (Clark et al., 1998). An independent central bank may suggest to the public thatmonetary policy may be shielded from extreme government ideology (Bernhard and Leblang, 2002). As a result, central bankindependence is a critically valuable commitment mechanism when accompanied with transparent and politically accountableinstitutions (De Haan et al., 2008).11 Previous literature indicates that greater central bank independence generates price stability(Eijffinger and De Haan, 1996; Crowe and Meade, 2008; Jácome and Vázquez, 2008; Eijffinger and Hoeberichts, 2008). Moreimportantly, a review of the literature suggests that substituting “exchange-rate based anchors” with central bank independenceallows the use of monetary policy for domestic targeting (Cukierman, 2008). Crowe and Meade (2008) suggest that a shift to amore flexible regime is linked with greater central bank independence.12 To sum, countries with greater central bankindependence are more likely to implement a flexible regime.

The process of globalization, which integrates the world economy into a single system, may also affect the choice of exchangerate policy. McKinnon (1963) explains that “openness” impacts the type of exchange rate regime a country employs. In addition,

7 Frieden and Stein (2001) suggest that weak governments are less likely to sustain a fixed regime.8 Fearon (1994) argues that governments suffer “audience costs” if they do not carry out the promised courses of actions.9 Kimakova (2008) also finds that a government with higher degree of accountability implements a flexible regime.

10 Frieden et al. (2010) indicates that policymakers in democratic countries may choose a fixed exchange rate regime to convincingly display to the public thattheir hands are tied in the analysis of 21 transition economies.11 In fact, Crowe and Meade (2008) find that higher central bank transparency causes the private sector to produce more precise forecasts with the informationgranted by the central bank.12 In addition, Berger et al. (2008) explain that countries with a flexible regime have larger monetary policy committees.

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Frieden (2008) emphasizes that global integration enhances the significance of the exchange rate regime. For example, countriesthat significantly depend on trade – open economies – are more likely to implement a fixed exchange rate regime because itreduces the volatility of exchange rates and transaction costs (Broz and Frieden, 2001). As a result, international partners have astable and predictable trading environment, thereby leading to greater cross-border economic interests and higher growth ininvestment (Bernhard and Leblang, 1999). Alternatively, flexible regimes generate exchange rate variability, and, in turn, produceunpredictability about international transactions and enhance risk premium to the costs of assets in cross-border trade (Broz et al.,2008). Thus, we argue that more globalized countries may favor a fixed exchange rate regime in order to lower risks associatedwith exchange rates that could potentially deter international trade and investment.

The structure of the financial system is also fundamentally important for the choice of exchange rate regime. Hossain (2009)indicates that the development of the financial system is imperative for the choice of flexible regime. Since the process of financialdevelopment decreases the usefulness of capital controls, Markiewicz (2006) explains that the principle of “impossible trinity” isbetween independent monetary policy and exchange rate stability. Hence, countries with low financial development select a fixedregime because they (1) do not have proper market tools to operate domestic openmarket operations (Markiewicz, 2006) and (2)need to protect their inexperienced banking sector from exchange rate volatility (von Hagen and Zhou, 2005). Hence, weanticipate that countries with greater financial development are more likely to choose a flexible exchange rate regime.

According to McKinnon (1963), economic size is also a crucial determinant of a choice of exchange rate regime. Smallereconomies favor a fixed regime because they are inclined to have high rates of participation in international trade (Markiewicz,2006). In other words, countries with higher level of economic development increase the probability of employing a flexibleregime (Poirson, 2001; Hossain, 2009). We also anticipate that the level of domestic interest rates affect the mobility ofinternational capital flows, and, in turn, to impact the exchange rate regime determination. Markiewicz (2006) explains that anincrease in the domestic interest rates may lead a country to choose a fixed regime due to elevated financial costs for thegovernment. Finally, high rates of inflationmay potentially weaken the international competiveness of an economy (Bodea, 2010).Thus, economies that experience high rates of inflation may possibly choose a fixed regime to reduce inflation, thereby rebuildingcompetitiveness in the tradable sector (Frieden and Stein, 2001).

3. Methodology and data

3.1. Econometric model

We employ a panel multinomial logit approach with fixed effects model due to the nature of the dependent variable.13 Thedependent variable is categorical variable that classifies the de facto exchange rate regime. The probability that the government iwill choose the exchange rate regime j classification (Pij) is distributed as follows:

Pitj = Pr Yitj N Yitk� �

; for k ≠ j; j = 1; ⋯n: ð1Þ

Eq. (1) denotes the unobserved utility that government i derives in year t from regime j, where Yij represents maximum utilityachieved from exchange rate regime for government i if the government chooses the j-th exchange rate regime classification. Inaddition,

Yij = α + β0

jXij + ηi + εij ð2Þ

where the dependent variable Y is the exchange rate regime classification. We define the fixed exchange rate regime as thebaseline category. βj is a vector of coefficients of each of the independent variables X, which are estimated via maximizing a loglikelihood function. The stochastic terms εij has the independent and Weibull distribution and ηi is an individual-specific, time-invariant effect. The multinomial logit model can be expressed as follows:

Pij = expðβ0

jXijÞ= Σexpðβ0

jXijÞ: ð3Þ

The multinomial logit regression is the most suitable model in a discrete choice analysis in a presence of more than twoalternatives in a choice set. The multinomial logit model is employed to examine the relationship between a categorical responsevariable, with more than two categories, and a set of explanatory variables (So and Kuhfeld, 1995). It is derived from the theory ofmaximum random utility that states that a government implements an exchange rate regime which maximizes its utility in theexchange rate regime selection. Under these conditions, a countrymay choose among several alternatives (different exchange rateregimes) as a function of a decision maker (government) and decision (exchange rate regime) attributes. An importantassumption of the multinomial logit model is that it implies that the decision between two different sets of alternatives isindependent from the presence of more alternatives. Further, it provides useful information in determining the correct type ofmodel to estimatemultinomial logit equations. Wei et al. (2005) employ a multinomial logit model to investigate the entry modes

13 The fixed-effects model calculates means for each variable and then subtracts the means; the constant and individual effects are also eliminated by thistransformation eliminating unobserved heterogeneity by taking deviations from individual means periods.

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of foreign direct investment in China. Also, Levy-Yeyati et al. (2010) utilize a multinomial logit approach to test the endogeneity ofexchange rate regimes.

3.2. Data analysis

The definitions, data sources and summary statistics for all the variables are reported in Table A1. We investigate exchange rateregime determination in a panel of 180 countries: 26 developed and 154 developing countries. The list of countries is reported inTable A2. The analysis is based upon data recorded annually over the period of 1974–2004. The data are extracted from severalsources, namely Levy-Yeyati and Sturzenegger (2005), Klomp and De Haan (2009), Cheibub et al. (2010), World Bank’s WorldDevelopment Indicators (20209), 2011 KOF Index of Globalization (Dreher, 2006, updated in Dreher et al., 2008), Database ofPolitical Institution (2010) and the Democracy Cross-national Data: Pippa Norris.

3.2.1. The dependent variable: the de facto exchange rate regimeThe dependent variable is exchange rate regime, more specifically, the de facto exchange rate regime constructed by Levy-Yeyati

and Sturzenegger (2005). The fundamental advantage of de facto exchange rate regime classification is that it represents the actualclassification of exchange rate regime rather than announced policies. Levy-Yeyati and Sturzenegger (2005) classify de facto exchangerate regimes in accordance with the performance of three classification variables: (a) exchange rate volatility, (b) volatility ofexchange rate changes and (c) volatility of international reserves. In what follows, we briefly define these classification variables, asdetailed in Levy-Yeyati and Sturzenegger (2005).

Exchange rate volatility represents “the average of the absolute monthly percentage changes in the nominal exchange rateduring a calendar year.” The volatility of exchange rate changes signifies “the standard deviation of the monthly percentagechanges in the exchange rate.” The volatility of international reserves refers to the “changes in reserves that reflects intervention inthe foreign exchangemarket”, which is computed by subtracting “government deposits at the central bank from the central bank’snet foreign assets.” Levy-Yeyati and Sturzenegger (2005) compute the three classification variables and employ cluster analysis asa technique to allocate data to different countries, thereby constructing the de facto exchange rate regime classification.14

To ensure robustness of the empirical results, we use two exchange rate regime classifications: (1) exchange rate 3-waysclassification (1 = float; 2 = intermediate; 3 = fix) and (2) exchange rate 5-ways classification (1 = inconclusive; 2 = float; 3 =dirty; 4 = dirty/crawling peg; 5= fix). Hence, our dependent variable is the de facto exchange rate regime 3-ways and 5-waysclassification (idx3 and idx5, respectively). Levy-Yeyati and Sturzenegger (2005) explain that observations that exhibit littlevariability cannot be effectively designated to any specific regime, and, consequently, are categorized as “inconclusive”. Thus, wedo not report the results for “inconclusive” in our empirical findings.

3.2.2. Explanatory variablesThe variable government ideology represents the ideological orientation of the respective government. We use three

alternativemeasures of government ideology.15 More specifically, we utilize the national election results characterized in the Becket al. (2001) Database of Political Institutions, which classifies the three largest government parties according to whether theyhave a left-wing, centrist or right-wing ideological orientation. Our first measure of government ideology (ideology1) is obtainedfrom Democracy Cross-national Data. Pippa Norris codes the variable executive party ideology for a country as follows: right-wingparties R, centrist parties C, and left-wing parties L. We follow the general approach in Dreher et al. (2010), and code left-winggovernments 1 and 0 otherwise. On the second measure of government ideology (ideology2), we follow the methodology inBjørnskov (2005b, 2008), and assign right-wing — 1, centrist 0, and left-wing 1, and weight single party ideologies with theirproportion of seats in the parliament. Our last measure of government ideology (ideology3) is a 5-year moving average data ofideology2. The variables ideology2 and ideology3 represent the “self-professed relative ideology of governments (Bjørnskov,2008:301).” For example, a “fully leftwing government throughout the period are assumed to have a population in which themajority has leftwing sympathies and ideology and which defines the policy set (Bjørnskov, 2008:301).”

Our democracy data comes from Cheibub et al. (2010), who build on the work of Alvarez et al. (1996) and Przeworski et al.(2000), which define institutions as democracy according to whether the chief executive office and the legislative body are filledby contested elections. Hence, an institution is categorized as a democracy if it fulfills the following four conditions: (1) “the chiefexecutivemust be chosen by popular election or by a body that was itself popularly elected”; (2) “the legislaturemust be popularlyelected”; (3) “there must be more than one party competing in the elections”; and (4) “an alternation in power under electoralrules identical to the ones that brought the incumbent to office must have taken place (Cheibub et al., 2010:69).”16 Hence, thevariable democracy is coded 1 if the respective government satisfies all the above requirements, 0 otherwise.

We obtain the election data from International Institute for Democracy and Electoral Assistance.We adjust the electoral timingat a 1 year lag, since many policies are purposely promoted prior to the elections with the intention of reelection. Arnone et al.(2007) build central bank independence indicator based on the general approach of Grilli et al. (1991) that differentiates between

14 For an extensive analysis of exchange rate regime classifications, including construction and methodology, see Levy-Yeyati and Sturzenegger (2005).15 We acknowledge that government ideology is difficult to measure, especially in developing countries. Nevertheless, previous literature has utilized the workof Beck et al. (2001) Database of Political Institutions to investigate the significance of government ideology.16 For an extensive analysis of the democracy data, including construction and methodology, see Cheibub et al. (2010).

43A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

the political autonomy (the ability of the central bank to choose the objectives of monetary policy) and economic autonomy (theability of the central bank to choose its instruments). Therefore, we use the central bank independence data from Klomp and DeHaan (2009), who follow the information on central bank law reforms in Acemoglu et al. (2008) and determine the value of thecentral bank independence index for all the periods for which Arnone et al. (2007) supply data.17

We utilize the overall globalization index (2011) originally developed by Dreher (2006), and further summarized by Dreheret al. (2008), who construct an index of globalization covering three main dimensions: economic, social and politicalintegration. Economic globalization refers to “long distance flows of goods, capital and services as well as information andperceptions that accompany market exchanges.” Political globalization represents “diffusion of government policies.” Socialglobalization epitomizes the “spread of ideas, information, images, and people.” These sub-indexes are, in turn, aggregatedinto one single index of overall globalization. 18 Norris (2000) describes the process of globalization as eroding “nationalboundaries, integrating national economies, cultures, technologies, and governance, producing complex relations of mutualinterdependence (p. 155).”

We incorporate additional explanatory variables to obtain efficient estimation results. We follow previous literature andemploy the real GDP (constant in 2000 and transformed in natural logarithms) to assess the level of economic performance invarious countries, based on the World Bank’s World Development Indicators (WDI, 2009). We utilize the domestic credit toprivate sector as a percentage of GDP to proxy for financial development, lending interest rates to represent the domestic interestrates and annual percentage change of consumer prices to denote the inflation rate, also extracted from WDI (2009).

4. Empirical results

To start, we investigate the relationship between our explanatory variables and the choice of exchange rate regime for the fullsample. Table 1 displays the estimation results. Subsequently, we analyze the influence of our explanatory variables on the choiceof exchange rate regime in our sample of developing and developed countries. Tables 2 and 3 report the empirical results. In theinterest of robustness, we report the estimation results for the dependent variable de facto exchange rate regime 3-ways and 5-ways classification (idx3 and idx5, respectively). We estimate a multinomial logit model with fixed-effects where the baselinecategory is a de facto fixed exchange rate regime. Hence, the parameters in Tables 1–3 demonstrate the impact of the independentvariables on the marginal utility of the choice of exchange rate regime under consideration relative to the baseline category— thefixed exchange rate regime. Further, the statistical significance of a parameter denotes the degree to which the correspondingindependent variable influences the marginal utility of the pertinent exchange rate regime relative to the baseline category— thefixed exchange rate regime.

4.1. Full sample

Consider first the influence of government ideology on the choice of exchange rate regime for the dependent variable idx3 inTable 1 (columns I, II and III). All our measures of ideology have the expected positive and statistically significant coefficient in allequations, suggesting that a left-wing government is more likely to implement a flexible regime and less likely to adopt a fixedregime. Our results are in line with the notion that left-wing governments favor a flexible regime to conduct monetary policy toachieve employment growth. We provide evidence that policymakers choose the type of exchange rate regime that conforms totheir political ideology since they have substantially different inclinations concerning macroeconomic objectives.

As anticipated, our findings indicate that democratic institutions increase the probability of choosing a flexible regime. Theseresults are also consistent with those of Leblang (1999) and Broz (2002). Further, central bank independence increases theprobability of selecting a flexible regime and decreases the probability of selecting a fixed regime. These results are reinforcedwiththose of Siklos (2008), who emphasizes that a flexible exchange rate regime delegates the responsibility for monetary policydecisions entirely to the central bank and highlights that a fixed exchange rate regime constraints the central bank to conductmonetary policy. Our findings also support the view that a shift to a more flexible exchange rate regime is associated with greatercentral bank independence (Crowe and Meade, 2008) and replacing “exchange-rate based anchors” with central bankindependence allows the use of monetary policy for domestic targeting (Cukierman, 2008).

In addition, the variable election has a positive and statistically significant coefficient, providing evidence that politiciansincrease the likelihood of implementing a flexible regime prior to elections. Our results are supported by the political businesscycle literature, which emphasizes that policymakers influence the exchange rate regime before the elections to facilitate outputgrowth in pursuit of electoral success. This is in line with the view that governmentsmay potentially strive to control the economyto make them a more “popular party”, as documented by Pissarides (1980). More importantly, this is consistent with the analysis

17 We are grateful to Professors Jeroen Klomp and Jakob de Haan for providing us with the data. We also appreciate the advice from Professor Axel Dreher inhandling this dataset.18 It is important to emphasize that globalization is a multi-dimensional concept that cannot be described by a single indicator, i.e. trade openness and foreigndirect investment (Simmons and Elkins, 2004; Potrafke, 2010b). Following previous studies, we emphasize that the overall globalization index is able to capturethe multi-dimensional characteristics of globalization because it includes economic, social and political integration.

44 A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

Table 1Multinomial logistic regression estimates: full sample.

Model Dependent variable: idx3 Dependent variable: idx5

I II III IV V VI

1 2 1 2 1 2 2 3 4 2 3 4 2 3 4

Constant −1.447⁎⁎

(−8.531)−1.113⁎⁎

(−6.178)−1.534⁎⁎

(−8.743)−1.167⁎⁎

(−6.364)−1.586⁎⁎

(−9.251)−1.236⁎⁎

(−6.864)−1.452⁎⁎

(−8.535)−2.436⁎⁎

(−9.404)−1.505⁎⁎

(−6.782)−1.542⁎⁎

(−8.763)−2.425⁎⁎

(−9.141)−1.595⁎⁎

(−7.114)−1.598⁎⁎

(−9.287)−2.475⁎⁎

(−9.474)−1.681⁎⁎

(−7.647)Ideology1 0.399⁎⁎

(3.312)0.279⁎⁎

(2.123)– – – – 0.401⁎⁎

(3.324)0.426⁎⁎

(2.301)0.219(1.384)

– – – – – –

Ideology2 – – 0.056⁎

(1.650)0.314⁎⁎

(3.274)– – – – – 0.057⁎

(1.728)0.371⁎⁎

(3.313)0.271⁎⁎

(2.316)– – –

Ideology3 – – – – 0.051⁎

(1.686)0.307⁎⁎

(3.426)– – – – – – 0.052⁎

(1.768)0.354⁎⁎

(3.308)0.282⁎⁎

(2.636)Democracy 0.307⁎⁎

(2.337)0.050(0.367)

0.494⁎⁎

(3.570)0.088(0.637)

0.532⁎⁎

(4.011)0.130(0.971)

0.307⁎⁎

(2.338)−0.140(−0.705)

0.154(0.952)

0.498⁎⁎

(3.598)−0.081(−0.403)

0.195(1.167)

0.535⁎⁎

(4.039)0.008(0.042)

0.204(1.270)

Globalization 0.002(0.161)

−0.023⁎

(−1.869)0.003(0.242)

−0.020(−1.587)

0.002(0.150)

−0.015(−1.258)

0.001(0.068)

−0.046⁎⁎

(−2.554)−0.022(−1.506)

0.002(0.142)

−0.043⁎⁎

(−2.321)−0.020(−1.299)

0.001(0.011)

−0.035⁎

(−1.959)−0.017(−1.165)

cbi 0.960⁎⁎

(3.311)0.802⁎⁎

(2.525)1.091⁎⁎

(3.625)0.944⁎⁎

(2.861)1.072⁎⁎

(3.628)0.942⁎⁎

(2.910)0.957⁎⁎

(3.291)1.369⁎⁎

(3.054)0.376(0.977)

1.093⁎⁎

(3.628)1.466⁎⁎

(3.149)0.547(1.369)

1.074⁎⁎

(3.633)1.381⁎⁎

(3.018)0.634(1.619)

Election 0.258⁎

(1.943)0.214(1.472)

0.286⁎⁎

(2.125)0.195(1.320)

0.299⁎⁎

(2.261)0.228(1.576)

0.256⁎

(1.929)0.143(0.684)

0.255(1.480)

0.284⁎⁎

(2.113)0.109(0.517)

0.244(1.390)

0.298⁎⁎

(2.256)0.137(0.660)

0.276(1.611)

rgdp −0.521⁎

(−1.935)0.295(1.048)

−0.473⁎

(−1.705)0.239(0.833)

−0.501⁎

(−1.844)0.188(0.670)

−0.517⁎

(−1.912)−0.199(−0.472)

0.817⁎⁎

(2.398)−0.465⁎

(−1.669)−0.213(−0.501)

0.757⁎⁎

(2.176)−0.489⁎

(−1.793)−0.227(−0.548)

0.684⁎⁎

(2.004)Financial development 0.005⁎⁎

(3.392)−0.001(−0.817)

0.004⁎⁎

(2.680)−0.001(−0.566)

0.004⁎⁎

(3.168)−0.001(−0.445)

0.005⁎⁎

(3.419)0.004⁎

(1.765)−0.003⁎

(−1.715)0.004⁎⁎

(2.684)0.004⁎

(1.897)−0.003(−1.514)

0.004⁎⁎

(3.201)0.004⁎

(1.846)−0.003(−1.336)

Inflation −0.001(−0.124)

0.001⁎

(1.713)0.001(0.082)

0.001⁎

(1.842)0.001(−0.150)

0.001⁎

(1.830)−0.001(−0.186)

0.002⁎

(1.710)−0.002⁎⁎

(−3.455)0.001(0.020)

0.002⁎

(1.839)−0.002⁎⁎

(−3.364)−0.001(−0.336)

0.002⁎

(1.802)−0.002⁎⁎

(−3.441)Interest rate −0.001

(−0.574)−0.001(−1.523)

−0.001(−0.577)

−0.001(−1.441)

−0.001(−0.522)

−0.001(−1.483)

−0.001(−0.908)

0.001(0.448)

−0.002(−1.266)

−0.001(−1.055)

0.001(0.389)

−0.002(−1.414)

−0.001(−0.967)

0.001(0.584)

−0.002(−1.327)

Log likelihood −1958.527 −1889.920 −1972.564 −2452.351 −2372.364 −2480.617LR chi2 87.520 106.640 116.900 173.340 192.530 199.170Pseudo R2 0.022 0.027 0.029 0.034 0.039 0.039

Notes: The dependent variable idx3 is a categorical variable that takes the value 1 if a country is classified as a de facto flexible exchange rate regime, 2 if intermediate and 3 if fixed. The dependent variable idx5 is acategorical variable that takes the value 2 if a country is classified as a de facto flexible exchange rate regime, 3 if dirty, 4 if dirty/crawling peg, and 5 if fixed. Multinomial logit regression estimates with fixed-effects where thereference category is the fixed regime. The regressions include year dummies. The z-statistics are in parentheses.⁎⁎ Indicates the statistical significance at the 5% level.⁎ Indicates the statistical significance at the 10% level.

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Table 2Multinomial logistic regression estimates: developing countries.

Model Dependent variable: idx3 Dependent variable: idx5

I II III IV V VI

1 2 1 2 1 2 2 3 4 2 3 4 2 3 4

Constant −1.082**(−4.884)

−1.070**(−4.816)

−1.076**(−4.757)

−0.900**(−4.102)

−1.109**(−5.009)

−0.969**(−4.525)

−1.077**(−4.853)

−2.327**(−7.008)

−1.517**(−5.817)

−1.086**(−4.780)

−2.036**(−6.168)

−1.401**(−5.455)

−1.120**(−5.036)

−2.063**(−6.409)

−1.494**(−5.955)

Ideology1 0.659**(4.187)

0.609**(3.776)

– – – – 0.646**(4.105)

0.737**(3.211)

0.561**(3.024)

– – – – – –

Ideology2 – – 0.056**(2.942)

0.045**(2.394)

– – – – – 0.056**(2.942)

0.047**(2.348)

0.041*(1.943)

– – –

Ideology3 – – – – 0.058**(3.042)

0.044**(2.369)

– – – – – – 0.058**(3.048)

0.047**(2.333)

0.040*(1.910)

Democracy 0.356**(2.424)

0.301**(2.047)

0.705**(4.482)

0.469**(3.124)

0.748**(4.931)

0.472**(3.272)

0.350**(2.387)

−0.050(−0.227)

0.470**(2.744)

0.701**(4.477)

0.145(0.646)

0.630**(3.572)

0.743**(4.919)

0.164(0.761)

0.625**(3.680)

Globalization 0.062**(4.558)

0.023(1.604)

0.061**(4.319)

0.030**(2.103)

0.065**(4.702)

0.033**(2.371)

0.064**(4.596)

0.010(0.457)

0.017(1.005)

0.061**(4.294)

0.017(0.777)

0.024(1.431)

0.064**(4.633)

0.021(1.018)

0.026(1.588)

cbi 0.404(1.064)

0.482(1.254)

0.488(1.241)

0.279(0.707)

0.432(1.121)

0.341(0.885)

0.427(1.123)

1.117**(1.962)

0.142(0.321)

0.531(1.348)

0.771(1.302)

0.012(0.026)

0.475(1.233)

0.727(1.261)

0.146(0.329)

Election 0.218(1.307)

−0.164(−0.912)

0.200(1.167)

−0.118(−0.654)

0.243(1.452)

−0.139(−0.785)

0.220(1.318)

−0.355(−1.224)

−0.100(−0.493)

0.209(1.219)

−0.245(−0.860)

−0.076(−0.372)

0.251(1.502)

−0.235(−0.851)

−0.111(−0.549)

rgdp −0.604**(−1.976)

0.071(0.230)

−0.567*(−1.796)

−0.027(−0.087)

−0.494(−1.599)

−0.108(−0.356)

−0.619**(−2.015)

−0.421(−0.906)

0.517(1.409)

−0.567*(−1.788)

−0.491(−1.052)

0.419(1.125)

−0.490(−1.576)

−0.581(−1.285)

0.342(0.939)

Financial development −0.002(−0.828)

0.001(0.074)

−0.009**(−3.172)

−0.003(−1.164)

−0.009**(−3.352)

−0.002(−0.839)

−0.002(−0.895)

0.003(1.003)

−0.001(−0.223)

−0.009**(−3.224)

−0.001(−0.023)

−0.003(−1.202)

−0.010**(−3.398)

0.001(0.163)

−0.002(−0.910)

Inflation −0.001(0.660)

0.001*(1.647)

0.001(0.812)

0.001*(1.849)

0.001(0.754)

0.001*(1.875)

0.001(1.144)

0.002**(2.113)

−0.002**(−2.251)

0.001(1.143)

0.002**(2.189)

−0.001**(−2.119)

0.001(1.015)

0.002**(2.085)

−0.001**(−2.119)

Interest rate −0.001(−0.578)

−0.001(−0.965)

−0.001(−0.550)

−0.001(−0.917)

−0.001(−0.500)

−0.001(−0.914)

−0.001(−1.073)

0.001(0.289)

−0.002(−1.389)

−0.001(−1.126)

0.001(0.233)

−0.002(−1.422)

−0.001(−1.066)

0.001(0.341)

−0.002(−1.367)

Log likelihood −1376.682 −1321.551 −1389.357 −1753.289 −1694.305 −1786.192LR chi2 90.420 96.760 109.720 162.000 161.870 174.780Pseudo R2 0.032 0.035 0.038 0.044 0.046 0.047

Notes: Same as Table 1.

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Table 3Multinomial logistic regression estimates: developed countries.

Model Dependent variable: idx3 Dependent variable: idx5

I II III IV V VI

1 2 1 2 1 2 2 3 4 2 3 4 2 3 4

Constant −2.033**(−7.279)

−3.410**(−4.705)

−2.027**(−7.348)

−2.857**(−3.624)

−1.979**(−7.244)

−3.109**(−3.752)

−2.057**(−7.320)

−4.965**(−4.319)

−3.111**(−3.515)

−2.054**(−7.402)

−4.375**(−3.615)

−2.651**(−2.749)

−2.009**(−7.308)

−4.527**(−3.633)

−3.074**(−3.032)

Ideology1 0.154(0.604)

0.115**(2.394)

– – – – 0.157(0.614)

0.120**(2.341)

0.170(0.419)

– – – – – –

Ideology2 – – 0.174(0.593)

0.414(1.167)

– – – – – 0.182(0.619)

0.421(0.987)

0.484(0.961)

– – –

Ideology3 – – – – 0.473(1.339)

0.930**(2.158)

– – – – – – 0.481(1.357)

0.872*(1.678)

1.148*(1.898)

Democracy 0.199**(7.171)

0.222(0.315)

0.199**(7.254)

−0.024(−0.032)

0.195**(7.147)

0.176(0.227)

0.202**(7.211)

0.576(0.508)

−0.101(−0.118)

0.202**(7.307)

0.282(0.241)

−0.245(−0.268)

0.197**(7.210)

0.382(0.321)

0.079(0.084)

Globalization −0.145**(−4.305)

−0.126**(−3.326)

−0.140**(−4.267)

−0.109**(−2.922)

−0.145**(−4.405)

−0.110**(−2.940)

−0.149**(−4.407)

−0.158*(−3.330)

−0.087*(−1.692)

−0.145**(−4.377)

−0.151**(−3.234)

−0.057(−1.114)

−0.149**(−4.503)

−0.152**(−3.244)

−0.061(−1.213)

cbi 0.108(0.157)

0.754(0.970)

−0.358(−0.512)

0.087(0.109)

−0.243(−0.351)

0.225(0.285)

0.102(0.147)

1.025(1.080)

0.350(0.319)

−0.359(−0.509)

0.485(0.504)

−0.503(−0.444)

−0.265(−0.381)

0.521(0.544)

−0.167(−0.151)

Election 0.114(0.443)

−0.218(−0.712)

0.117(0.455)

−0.185(−0.608)

0.107(0.418)

−0.144(−0.477)

0.122(0.474)

−0.142(−0.389)

−0.353(−0.787)

0.127(0.490)

−0.163(−0.448)

−0.215(−0.494)

0.116(0.450)

−0.137(−0.376)

−0.156(−0.371)

rgdp −0.308(−0.331)

0.613(0.602)

−0.101(−0.110)

0.221(0.213)

−0.266(−0.293)

0.105(0.102)

−0.278(−0.297)

0.390(0.302)

0.943(0.683)

−0.070(−0.076)

0.276(0.213)

0.145(0.103)

−0.224(−0.245)

0.372(0.289)

−0.202(−0.143)

Financial development 0.038**(8.962)

0.023**(5.085)

0.038**(8.790)

0.025**(5.288)

0.038**(8.993)

0.025**(5.277)

0.039**(8.986)

0.029**(5.414)

0.015**(2.251)

0.039**(8.837)

0.030**(5.505)

0.017**(2.580)

0.039**(9.040)

0.030**(5.518)

0.017**(2.559)

Inflation −0.033(−1.252)

−0.011(−0.430)

−0.027(−1.037)

−0.003(−0.105)

−0.017(−0.687)

0.002(0.067)

−0.035(−1.316)

−0.040(−1.165)

0.022(0.647)

−0.029(−1.105)

−0.033(−0.933)

0.031(0.896)

−0.019(−0.746)

−0.031(−0.872)

0.038(1.110)

Interest rate 0.083**(2.105)

0.147**(3.382)

0.071*(1.852)

0.133**(3.141)

0.055(1.470)

0.126**(3.036)

0.086**(2.154)

0.178**(3.559)

0.106*(1.901)

0.074*(1.905)

0.163**(3.345)

0.096*(1.788)

0.057(1.516)

0.162**(3.289)

0.082(1.538)

Log likelihood −411.749 −404.022 −410.307 −507.944 −500.374 −508.274LR chi2 271.880 276.820 289.990 308.8 313.160 327.290Pseudo R2 0.248 0.255 0.261 0.233 0.238 0.244

Notes: Same as Table 1.

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by Bernhard and Leblang (1999), who argue that policymakers utilize any policy instruments that can increase their probability ofreelection.

Next, we demonstrate that the effect of globalization on exchange rate regime is less strong, and it appears to lose statisticalsignificance in two specifications. Nevertheless, we display that more globalized countries have a higher probability ofimplementing a fixed regime and no significant effect on choosing a flexible regime (column I). These results are in line with thoseof Frieden et al. (2010), who display that countries which are more “open to the world economy” are associated with fixedexchange rate regimes (p. 2). Also, the variable financial development has the expected positive and statistically significantcoefficient in all equations, implying that countries with higher financial development are more likely to favor a flexible regime.These results are also in line with those of von Hagen and Zhou (2005), Markiewicz (2006) and Frieden et al. (2010).

We find that an increase in the level of economic development decreases the probability of choosing a flexible regime. Althoughthis effect is less strong, our findings are not consistent to those of Markiewicz (2006) and Hossain (2009), who discover thatlarger economies prefer a flexible exchange rate regime. We demonstrate that countries experiencing higher rates of inflation areless likely to employ a fixed regime and no significant effect on choosing a flexible regime. These results parallel the empirical workof Markiewicz (2006) and Frieden et al. (2010), who display that economies with higher inflation rates are associatedwith a lowerlikelihood of a fixed exchange rate regime.19 Finally, we show that the level of domestic interest rates do not impact the choice ofexchange rate regime.

Next, we turn to investigate the numerical significance of our findings. The probability of choosing a flexible regime (orintermediate regime) relative to the fixed regime can be explained with the odds ratio. We compute the odds ratio by taking theexponential function of the multinomial logistic regression estimates of each independent variable (exp [X]). Hence, a variablewith an odds ratio larger than 1 (smaller than 1) indicates higher likelihood (lower likelihood) of implementing a flexible regimerelative to the fixed regime. Alternatively, a variable with an odds ratio of 1 implies no relationship with exchange rate regimeselection.

For the dependent variable idx3, a left-wing government (ideology1) has a 49% higher probability to implement a flexibleregime, compared to a fixed regime (exp [0.399]). This magnitude seems to be smaller for ideology2 and ideology3: left-winggovernments have a 5.8% and 5.2% higher likelihood to choose a flexible regime relative to a fixed regime, respectively. Also, ademocratic institution has a is 35.9% higher probability to choose a flexible regime relative to a fixed regime than non-democracies(exp [0.307]); central bank independence seems to have the largest magnitude, with 161% higher probability to choose a flexibleregime (exp [0.960]); further, a government is 29.4% more likely to implement a flexible regime prior to elections (exp [0.258]).

Overall, all our estimated results are robust to the dependent variable de facto exchange rate regime 5-ways classification(columns IV, V and VI). In what follows, we attempt to discover differences, if any, on the choice of exchange rate regime in oursample of developing and developed countries.

4.2. Developed vs. developing countries

For a deeper investigation, we proceed to uncover some interesting differences in our sample of developed and developingcountries. Tables 2 and 3 display the results for our sample of developing and developed countries, respectively. We begin ouranalysis with the variable government ideology. For developing countries (Table 2), the results suggest that left-winggovernments are more likely to choose a flexible regime and less likely to choose a fixed regime. These results are in line with thefull sample. However, for developed countries (Table 3), a left-wing government decreases the probability of choosing a fixedregime and no significant effect in the probability of choosing a flexible regime.We demonstrate that left-wing governments favora flexible exchange rate regime, particularly in developing countries. Overall, we provide strong evidence that governmentideology is an important determinant of the choice of exchange rate regime in different economies.

In addition, democratic institutions in developing and developed countries increase the probability of implementing a flexibleregime and decrease the probability of a fixed regime. These results are, again, consistent with the full sample. We display supportthat democratic countries in developed and developing economies declare a flexible exchange rate regime since they are morepolitically accountable institutions (Broz, 2002), facilitate greater information to the public (Fearon, 1994) and incur higherdemands to utilize more expansionary monetary policy (Leblang, 1999). We also discover that electoral motives and central bankindependence do not influence the choice of exchange rate regime in our samples of developing and developed countries.

Further, we display clear differences on the effect of globalization on the choice of exchange rate regime in developing anddeveloped countries. For developed countries, more globalized economies have a higher likelihood of choosing a fixed regime andlower likelihood of choosing a flexible regime. This effect is statistically significant in most equations, providing strong evidencethat more globalized economies in developed countries favor a fixed exchange rate regime to lower the risks associated withexchange rate variability that may impede international trade and investment. These results are also in line with the full sample.Alternatively, we discover that more globalized economies in developing countries are more likely to choose a flexible regime andless likely to choose a fixed regime.

19 Nevertheless, high inflation rates significantly challenge the credibility of a fixed regime, which, in turn, suggest that moving to a flexible regime may not be apolitical decision. Further, it is possible that economies experience low rates of inflation as a result of a fixed regime. We are grateful to one anonymous refereewho suggested this possibility.

48 A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

Overall, our model demonstrates interesting implications on the effect of globalization: developed economies prefer a fixedexchange rate regime, whereas developing economies favor a flexible exchange rate regime in the presence of higher levels ofglobal integration. More recently, developing economies experienced a considerable increase in capital flows and trade openness,and hence are extremely involved with their competitiveness in international markets (Goldberg and Pavcnik, 2007). As a result,developing countries may adopt a flexible regime as opposed to “tie their hands” as a fixed regime in order to enable speedychange of the exchange rates and to circumvent lengthymisalignments (von Hagen and Zhou, 2007). In addition, a flexible regimepermits the government to regulate the nominal exchange rate to assure the competitiveness in the tradable sector (Broz andFrieden, 2001). For instance, Frieden (2008) and Frieden et al. (2010) emphasize that the tradable producers favor a flexibleregime to permit exchange rate policy to influence the competiveness in the tradable sector. Levy-Yeyati and Sturzenegger (2001)also display that flexible regimes are significantly associated with greater economic growth in developing countries.20 Fordeveloped countries, the primary advantage of a fixed regime is to reduce the volatility of the exchange rate and transaction costs(Broz and Frieden, 2001). According to Frieden (2008), the exchange rate regime is also critically important for developedeconomies, as member countries of the European Union have endeavored “to stabilize their currencies” against each other forover thirty years (p. 354). Further, foreign investors disapprove the uncertainty connected with major instabilities in currency(Frieden et al., 2010). As a result, the more open countries have a greater likelihood of implementing a fixed regime (Frieden,2008).

In addition, higher levels of financial development in developed countries increase the likelihood of a flexible regime anddecrease the likelihood of a fixed regime. These findings are also in line with the full sample. However, developing economies withhigher financial development are more likely to choose a fixed regime. These results are in line with those of Levy-Yeyati et al.(2010), who find that greater financial integration among non-industrial economies increase the probability of choosing a fixedexchange rate regime. This is anticipated, since financial integration in developing countries is highly correlatedwith denominateddebt and greater currency mismatches (Eichengreen and Hausmann, 2005; Levy-Yeyati et al., 2010).

We also discover that an increase in the level of economic development decreases the likelihood of implementing a flexibleregime in developing countries. This effect is not statistically significant for developed countries. Further, developing countriesthat experience higher rates of inflation are less likely to employ a fixed regime and no significant effect on choose a flexibleregime. These results are, once more, consistent with the full sample. For developed countries, this effect is not statisticallysignificant. Finally, we show that developed economies with higher level of domestic interest rates are more likely to choose aflexible regime and less likely to choose a fixed regime. However, domestic interest rates do not impact the choice of exchange rateregime in developing countries. This is also consistent with the full sample.

As before, we examine the numerical significance of our results in the sub-sample analysis. For developing countries, thecoefficient of ideology1 shows that a left-wing government has 93% higher probability to implement a flexible regime relative to afixed regime, (exp [0.659]), whereas this effect is not significant for developed countries. Democratic institutions in developing anddeveloped countries have a 43% and 22% higher probability to choose a flexible regime than non-democracies, respectively. Ourmodel demonstrates interesting implications on the effect of globalization: developed economies have a 13.50% lower probabilityto choose a flexible regime, whereas developing economies have a 6.40% higher probability to choose a flexible regime. To sum, wefind considerable differences on the type of exchange rate regime a country implements between developing and developedeconomies. Overall, most of our estimated results for developing and developed countries are robust to the dependent variable defacto exchange rate regime 5-ways classification (Tables 2 and 3 columns IV, V and VI).

We also estimate ordered probit model to further support the robustness of our results. The results from the ordered probitestimation are displayed in Tables 4 and 5. Notice that all our variables of ideology are negative and statistically significant for thefull sample (columns I, II and III) and developing countries (columns IV, V and VI), suggesting that left-wing governments have ahigher probability of implementing a flexible regime. This effect is in line with the dependent variable idx3 and idx5. Alternatively,for developed countries (columns VII, VIII, and IX), this effect is less strong for the dependent variable idx3 and statisticallyinsignificant for the dependent variable idx5. The numerical relevance suggests that a 1 standard deviation increase in the variableideology1 increases the probability of choosing a flexible regime by about 3.59 percentage points in the full sample (0.178* 0.202),15.5 percentage points in the developing countries (0.474* 0.326) and 9.19 percentage points in the developed countries (0.489*0.188). Again, these findings further support that left-wing governments are more likely to choose a flexible regime, especially indeveloping economies. The remaining results from the ordered probit model are mostly in line with our multinomial logitregression estimates.

5. Conclusion

The present paper examines the effect of government ideology, political institutions and globalization on the choice ofexchange rate regime. In the case of the full sample, we demonstrate that government ideology, political institutions andglobalization are important determinants of the choice of exchange rate regime. In particular, we provide evidence that a left-winggovernment is more likely to implement a flexible regime and less likely to implement a fixed regime. Further, we show that

20 However, global integration together with a switch from a fixed to a flexible regime in many developing countries creates larger exchange rate variability,which, in turn, may impact income inequality, as documented by Goldberg and Pavcnik (2007).

49A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

Table 5Robustness checks: ordered probit regression estimates: dependent variable is idx5.

Model I II III IV V VI VII VIII IX

Full sample Developing countries Developed countries

Ideology1 −0.175⁎⁎

(−3.123)– – −0.312⁎⁎

(−4.518)– – −0.124

(−1.161)– –

Ideology2 – −0.040⁎⁎

(−2.112)– – −0.017⁎⁎

(−3.113)– – −0.081

(−0.640)–

Ideology3 – – −0.037⁎⁎

(−2.216)– – −0.018⁎⁎

(−3.160)– – −0.200

(−1.323)Democracy −0.107⁎

(−1.786)−0.173⁎⁎

(−2.793)−0.183⁎⁎

(−3.089)−0.125⁎

(−1.918)−0.246⁎⁎

(−3.648)−0.255⁎⁎

(−3.936)0.288(1.180)

0.527⁎

(1.935)0.550⁎⁎

(1.981)Globalization −0.004

(−0.795)−0.005(−0.922)

−0.004(−0.848)

−0.028⁎⁎

(−4.739)−0.028⁎⁎

(−4.545)−0.030⁎⁎

(−4.939)0.062⁎⁎

(4.595)0.056⁎⁎

(4.169)0.056⁎⁎

(4.176)cbi −0.370⁎⁎

(−2.740)−0.414⁎⁎

(−2.967)−0.407⁎⁎

(−2.974)−0.122(−0.728)

−0.148(−0.857)

−0.121(−0.714)

−0.580⁎⁎

(−2.119)−0.304(−1.088)

−0.290(−1.052)

Election −0.124⁎⁎

(−2.003)−0.135⁎⁎

(−2.150)−0.154⁎⁎

(−2.510)−0.044(−0.582)

−0.051(−0.662)

−0.073(−0.970)

−0.108(−0.991)

−0.095(−0.865)

−0.097(−0.900)

rgdp 0.170(1.353)

0.151(1.174)

0.163(1.298)

0.144(1.043)

0.156(1.109)

0.138(1.007)

−0.306(−0.802)

−0.235(−0.607)

−0.131(−0.343)

Financial development −0.002⁎⁎

(−2.461)−0.001⁎⁎

(−2.050)−0.002⁎⁎

(−2.485)0.001(0.958)

0.003⁎⁎

(2.976)0.003⁎⁎

(3.001)−0.011⁎⁎

(−7.926)−0.011⁎⁎

(−7.960)−0.011⁎⁎

(−8.278)Inflation −0.001

(−0.339)−0.001(−0.603)

−0.001(−0.476)

−0.001(−0.499)

−0.001(−0.871)

−0.001(−0.813)

0.002(0.200)

−0.001(−0.061)

−0.004(−0.397)

Interest rate 0.001(0.285)

0.001(0.154)

0.001(0.167)

−0.001(−0.131)

−0.001(−0.281)

−0.001(−0.312)

−0.029⁎⁎

(−1.994)−0.024(−1.635)

−0.018(−1.281)

Log likelihood −2515.696 −2438.625 −2546.694 −1798.412 −1742.021 −1835.809 −607.231 −594.961 −603.985LR chi2 46.650 60.010 67.020 71.760 66.440 75.550 110.230 123.990 135.870Pseudo R2 0.009 0.012 0.013 0.020 0.019 0.020 0.083 0.094 0.101

Notes: The z-statistics are in parentheses.⁎⁎ Indicates the statistical significance at the 5% level.⁎ Indicates the statistical significance at the 10% level.

Table 4Robustness checks: ordered probit regression estimates: dependent variable is idx3.

Model I II III IV V VI VII VIII IX

Full sample Developing countries Developed countries

Ideology1 −0.202⁎⁎

(−3.435)– – −0.326⁎⁎

(−4.455)– – −0.188⁎

(−1.646)– –

Ideology2 – −0.038⁎

(−1.934)– – −0.021⁎⁎

(3.428)– – −0.139

(−1.024)–

Ideology3 – – −0.036⁎⁎

(−2.022)– – −0.021⁎⁎

(3.523)– – −0.310⁎

(−1.877)Democracy −0.143⁎⁎

(−2.281)−0.223⁎⁎

(−3.450)−0.245⁎⁎

(−3.944)−0.175⁎⁎

(−2.565)−0.329⁎⁎

(−4.640)−0.348⁎⁎

(−5.106)−0.719⁎⁎

(−2.009)−0.618(−1.573)

−0.667⁎

(−1.648)Globalization −0.001

(−0.057)−0.001(−0.167)

−0.001(−0.139)

−0.029⁎⁎

(−4.526)−0.028⁎⁎

(−4.358)−0.030⁎⁎

(−4.769)0.076⁎⁎

(5.130)0.071⁎⁎

(4.904)0.072⁎⁎

(4.964)cbi −0.490⁎⁎

(−3.476)−0.556⁎⁎

(−3.815)−0.546⁎⁎

(−3.821)−0.217(−1.236)

−0.259(−1.426)

−0.235(−1.326)

−0.520⁎

(−1.734)−0.299(−0.976)

−0.319(−1.055)

Election −0.130⁎⁎

(−2.003)−0.143⁎⁎

(−2.169)−0.151⁎⁎

(−2.331)−0.096(−1.196)

−0.082(−0.999)

−0.100(−1.248)

−0.069(−0.579)

−0.060(−0.501)

−0.067(−0.569)

rgdp 0.233⁎

(1.767)0.216(1.602)

0.232⁎

(1.766)0.274⁎

(1.881)0.272⁎

(1.829)0.248⁎

(1.713)−0.199(−0.480)

−0.227(−0.552)

−0.121(−0.296)

Financial development −0.002⁎⁎

(−3.207)−0.002⁎⁎

(−2.567)−0.002⁎⁎

(−3.050)0.001(0.545)

0.003⁎⁎

(2.920)0.003⁎⁎

(2.992)−0.015⁎⁎

(−9.360)−0.015⁎⁎

(−9.178)−0.015⁎⁎

(−9.485)Inflation −0.001

(−0.100)−0.001(−0.385)

−0.001(−0.309)

−0.001(−0.166)

−0.001(−0.560)

−0.001(−0.555)

0.003(0.275)

0.001(0.028)

−0.004(−0.357)

Interest rate 0.001(0.670)

0.001(0.526)

0.001(0.524)

0.001(0.131)

−0.001(−0.049)

−0.001(−0.090)

−0.035⁎⁎

(−2.267)−0.031⁎⁎

(−2.004)−0.024(−1.601)

Log likelihood −1970.090 −1904.561 −1987.047 −1385.102 −1329.583 −1397.985 −457.225 −451.026 −456.538LR chi2 64.390 77.360 87.930 73.580 80.700 92.460 180.930 182.810 197.530Pseudo R2 0.016 0.020 0.022 0.026 0.030 0.032 0.165 0.169 0.178

Notes: The z-statistics are in parentheses. **and* indicates the statistical significance at the 5% and 10% level, respectively.⁎⁎ Indicates the statistical significance at the 5% level.⁎ Indicates the statistical significance at the 10% level.

50 A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

democratic institutions, election motives, central bank independence and greater financial development increase the likelihood ofchoosing a flexible regime.We also display that more globalized countries have a higher probability of choosing a fixed regime andeconomies with higher rates of inflation are less likely to implement a fixed regime. Finally, countries that experience higher levelof economic development are less likely to choose a flexible regime.

Next, we uncover several differences on the choice of exchange rate regime in our sample of developing and developedcountries. For example, we show that a left-wing government in a developing economy is more likely to choose a flexible regime.For developed countries, a left-wing government decreases the probability of choosing a fixed regime and no significant effect ofchoosing a flexible regime. Also, our findings suggest that more globalized countries in developed economies favor a fixed regime,whereas developing economies prefer a flexible regime. Further, greater financial development in developed countries increasesthe probability of a flexible regime, though developing countries are more likely to choose a fixed regime.

We also show that economic development decreases the probability of a flexible regime in developing countries. In addition,higher rates of inflation in developing countries decrease the likelihood of a fixed regime. In contrast, the level of economicdevelopment and inflation rate does not impact the choice of exchange rate regime in developed countries. Finally, we discoverthat higher level of domestic interest rates in developed countries is more likely to choose a flexible regime. This effect is not,however, statistically significant for developing countries. More importantly, our estimated results are robust to the dependentvariable de facto exchange rate regime 5-ways classification, and the results from the robustness estimation provide strongevidence that our findings are robust in accordance with our baseline specification.

To sum, we find that government ideology, political institutions and globalization are fundamental determinants of the type ofexchange rate regime a country implements. More importantly, we highlight that political economy factors have different effectson the choice of exchange rate regime in developed and developing countries. It is therefore critically important to account for thepolitical economy variables in exchange rate policy decisions. In addition, we emphasize the significance of examining thedeveloped and developing country samples in order to devise adequate exchange rate policies, as we propose these implicationsfor further research.

Acknowledgements

We thank the editor and two anonymous referees for their helpful comments and suggestions. An earlier version of thispaper was completed while Chun-Ping Chang was a visiting scholar at the University of Kentucky. Chun-Ping Chang is gratefulto the National Science Council of Taiwan for financial support through grant NSC 99-2410-H-158-001. All remaining errors areour own.

Appendix A

Table A1Data definitions, sources and descriptive statistics.

Variable Definition Source Mean Standarddeviation

Observations

idx3 De facto exchange rate 3-waysclassification: (1 = float; 2 = intermediate; 3 = fixed).

Levy-Yeyati and Sturzenegger(2005)

2.4509 0.7943 4222

idx5 De facto exchange rate 5-waysclassification (1 = inconclusive; 2 = float;3 = dirty; 4 = dirty/crawling peg; 5 = fixed)

Levy-Yeyati and Sturzenegger(2005)

4.1404 1.2547 4287

Ideology1 Dummy variable coded 1 if the government is a left-wing party Democracy Cross-national Data:Pippa Norris

0.3535 0.1781 3875

Ideology2 The ideology of government party (-1: right; 0: central; 1: left)weighted by the share of seats in parliament

Database of Political Institution(2010)

0.1226 0.4931 3847

Ideology3 The 5-years moving average data of ideology2 Database of Political Institution(2010)

0.1153 0.4514 4371

Democracy 1 if the regime is democratic, 0 otherwise Cheibub et al. (2010) 0.4497 0.1975 5003Globalization Overall globalization index 2011 KOF Globalization Index 43.8481 16.9385 5138cbi Central bank independence index Klomp and De Haan (2009) 0.4836 0.2118 4557Election The election date of 1-year lag International Institute for

Democracy and Electoral Assistance0.1521 0.0591 5580

rgdp Real GDP (constant in 2000, natural logarithms) World Development Indicator(2009)

22.9759 2.3987 4758

Financialdevelopment

Domestic credit to private sector(% of GDP) World Development Indicator(2009)

39.0071 34.9796 4411

Inflation Inflation, consumer prices (annual %) World Development Indicator(2009)

23.1465 7.2340 4189

Interest rate Lending interest rate (%) World Development Indicator(2009)

18.4024 6.8615 3421

51A.N. Berdiev et al. / European Journal of Political Economy 28 (2012) 38–53

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