Let it float: Inflation and states’ priority on monetary independence over exchange rate stability

Abstract

Monetary policy autonomy and exchange rate stability are desirable macroeconomic policies that cannot be attained jointly under internationally mobile capital. In this article, I explore what happens to state choices between the two policies when a key domestic economic challenge rises. Among many factors, increasing inflation directly affects citizens’ daily lives through rising living costs and decreasing purchasing power. Because dissatisfied citizens become more likely to threaten leaders’ tenure in both democracies and nondemocracies, I argue that leaders will pay closer attention to domestically oriented citizens’ interest rather than that of internationally/export-oriented actors when the inflation rate increases. In other words, to effectively tackle inflation and appease citizens’ discontent, leaders will prioritize their ability to utilize monetary policy over stable exchange rates that promote international trade and investment. As a result, states become more likely to relax exchange rates as the inflation rate increases. Interestingly, empirical results indicate stronger support for hypotheses regarding nondemocratic states.