National culture and the choice of exchange rate regime

Abstract

Based on the social analysis framework of Williamson, we argue that national culture – especially the individualism/collectivism dimension – located in the social embeddedness level can guide behaviors and decisions in a country, including the choice of exchange rate regime. We argue that individualistic societies are more likely to choose floating regimes because their economic agents are independent, overconfident, and have higher levels of risk tolerance. Individualistic societies are also associated with better financial development, fewer capital controls, and more democratic institutions, which are all tied to a higher probability of choosing a floating exchange rate regime. We use data on 78 countries over the 1976–2014 period, and we control for common determinants of exchange rate regimes. We find that individualistic countries have a significantly higher probability of implementing a floating regime than a fixed regime. Our evidence is robust to using an instrumental variables approach, an alternative estimation technique, an alternative regime classification, alternative proxies for culture, a subsample analysis, and additional controls. We also find that other cultural dimensions (uncertainty avoidance, power distance, and masculinity) can influence the choice of exchange rate regime, but their effect is weaker than that of individualism.