Exchange Rate Regime Preferences and Budget Deficits in Open Economies

Abstract

This study investigates the impacts of exchange rate regime (ERR) choice, economic, institutional, and demographic factors on the budget deficit. The recent literature states that fiscal discipline is affected by the ERR preferences in open economies. In this study, the effect of de facto ERR preferences on fiscal discipline were analyzed between 1995 and 2016 for 76 countries classified into income groups. The estimates by Feasible Generalized Least Squares and Panel Corrected Standard Errors estimators show that flexible ERRs provide much more fiscal discipline. The findings highlight the importance of institutional quality, demographic factors, and inflation to ensure fiscal discipline. A country with a high level of trade openness is more vulnerable to exchange rate shocks, which leads to uncertainty in the fiscal policy. The results confirm that ERR preferences affect countries' fiscal disciplines differently, depending on the countries' characteristics.