Economic Shocks and Civil Conflict: Evidence from Foreign Interest Rate Movements

We exploit annual variation in influential foreign interest rates to identify externally-driven components of short-run income shocks in small open economies from 1971-2004 and explore the statistical nature of the income-civil conflict nexus. Our results show that movements in foreign interest rates have important effects on civil conflict risk through domestic economic channels. More importantly, the income-conflict relationship is found to be nonlinear – the conflict risk of ethnolinguistically fragmented countries is found to be much more sensitive to shifts in economic conditions than that of homogeneous countries. These results suggest an important mechanism by which short-term economic shocks affect the trajectory of the political and economic performance of ethnically divided states.