Remittances, Exchange Rate Regimes, and Central Bank Independence

What is the effect of remittances on countries’ choices of exchange rate regimes? Remittances are the second-largest source of foreign income for developing countries, only behind foreign direct investment.  This paper explores how the reception of remittances affects the probability of adopting different exchange rate regimes.  Previous research has shown that remittances, by easing the “impossible trilemma,” increase the probability of governments adopting fixed exchange rates.  However, these findings do not fully account for the conditioning effect of institutions – both monetary and political. This manuscript shows that remittances, by altering recipient governments’ incentives to use monetary policy counter-cyclically, increase the credibility of central bank independence in autocracies. As a result, autocracies can substitute central bank independence for fixed exchange rates as a signaling mechanism. Statistical analyses on a sample of 134 developing countries between 1980 and 2012, using new data on central bank independence, show that autocracies with an independent central bank are more likely to adopt flexible exchange rates in the presence of remittances.

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