Real exchange rate cycles around elections

Abstract

We develop the implications of political budget cycles for real exchange rates in a two-sector small open economy with a cash-in-advance constraint. Policy makers are office motivated politicians. Voters have incomplete information on the competence and the opportunism of incumbents. Devaluation acts like a tax, and is politically costly because it can signal the government is incompetent. This provides incumbents an incentive to postpone a devaluation, and can lead to an overvalued exchange rate before elections. We compare the implied cycle of appreciated/depreciated exchange rates to empirical evidence around elections from Latin America.exchange rate overvaluation, seigniorage, political budget cycle, asymmetric information.