Electoral Uncertainty and the Volatility of International Capital Flows

Abstract

I study a small open economy in which elections affect and are affected by capital inflows. Two candidates, one favoring workers and another favoring entrepreneurs, run for office; the winner chooses taxes, which affect investment returns. A pro labor victory results in a "sudden stop" in investment and capital flows, reflecting a time inconsistency problem. The pro business candidate is free from time inconsistency but becomes less attractive to voters if the foreign debt is larger. Hence electoral outcomes depends on the size of the debt, which itself depends on expectations about the election. The model's politico economic equilibria has several implications. Politico economic links exacerbate the responses of financial variables to exogenous shocks. Self fulfilling equilibria may exist. Policies that alleviate the pro labor candidate's commitment problem contribute to financial stability but also, and perhaps more surprisingly, to the chances of a pro labor victory in the elections. A redistribution of wealth has ambiguous although predictable effects on politico economic outcomes.