The Political Economy of Exchange Rate Regime in Developing Countries

The main purpose of this study is to investigate the extent and manner of the impact of political economy factors on the de facto exchange rate regime in developing countries and to extract implications for the political economy of the Iranian exchange rate regime. In this study, using ordered logit and probit models, we examine the impact of trade, financial, and political economy factors on the real exchange rate regime in middle-income developing countries during the period 1996-2012. The results of the research show that in the sample, an increase in the size of the economy increases the likelihood of choosing a floating exchange rate regime, and an increase in institutional quality, government strength, the power of interest groups, the level of democracy, and oil rents increases the likelihood of choosing a fixed exchange rate regime. Another conclusion is that the political economy factors have different effects on the choice of exchange rate regime in developing countries with upper-than-average incomes and developing countries with lower-than-average incomes. As a result, given that in developing countries the political economy factors have a significant impact on the choice of exchange rate regime, and since the influence of political economy factors on the choice of exchange rate regime leads to the adoption of a non-optimal currency system, policymakers in these countries need to reconsider how they choose the currency system. Also, according to the experimental results of this study, developing countries with poor institutional quality such as Iran are not able to maintain a stable exchange rate regime.