Political budget cycles in a small, open economy : the independent central bank as an institutional constraint conditional on the exchange rate regime

Abstract

This thesis investigates political budget cycles (PBC) in a modern democracy. A model of PBC in a small, open economy is developed using the New-Keynesian methodology, incorporating separate fiscal and monetary authorities. The model is based on that the competence of the politicians cannot be directly observed, and that the interest rate is a variable of high visibility for consumers. The model predicts that if there are no constraints to the central bank in the form of nominal limits to the exchange rate, there will be no PBC. An empirical analysis tests the model predictions on a panel data set of 141 countries over the years 1990-2009, and finds that they have good support. The lesson that can be drawn from this thesis is that an independent central bank is not by itself a hindrance to PBC. An independent central bank will only be an institutional constraint to politicians if there are no constraints that bind the central bank.