Academic journal article Journal of Money, Credit & Banking

Does Political Instability Lead to Higher Inflation? A Panel Data Analysis

Academic journal article Journal of Money, Credit & Banking

Does Political Instability Lead to Higher Inflation? A Panel Data Analysis

Article excerpt

THE MAIN PURPOSE of this paper is to empirically determine the main causes of the worldwide diversity of inflationary experiences, a challenge not yet satisfactorily confronted by the profession for two fundamental reasons. First, empirical models explaining inflation in the literature generally fail to account for inflation inertia and for the endogeneity of important economic and political variables affecting inflation. We use system-generalized method of moments (GMM) estimation applied to dynamic panel data to address some of the econometric limitations of the OLS models previously used in the literature. Second, several political variables used as explanatory variables in earlier studies were relatively poorer measures of political instability than those available in new datasets, such as the Database of Political Institutions from Beck et al. (2001) and the Cross National Time Series Data Archive. The use of these and other data sources combined with modern econometric techniques might provide more accurate estimations of the relationships between inflation and political instability.

Relying upon the theoretical literature and using a dataset covering around 100 countries for the period 1960-99, we investigate the main economic and political determinants of inflation. After controlling for the countries' economic structure and for the behavior of economic variables that may influence inflation, we find that political instability leads to higher inflation. Moreover, the impact of political instability on inflation is much stronger for high inflation than for moderate and low inflation countries, and also for developing than for industrial nations. Additionally, we find that institutions such as economic freedom and democracy are also important determinants of inflation. In particular, higher degrees of economic freedom and democracy are associated with lower inflation.

The paper is structured as follows. A survey of the empirical and theoretical literature on the relationship between inflation, political instability and institutions is presented in Section 1. The dataset and the empirical models are described in Section 2. Section 3 presents the empirical results and Section 4 concludes the paper.

1. POLITICAL INSTABILITY, INSTITUTIONS AND INFLATION

Most economists acknowledge that differences in monetary and fiscal policies among countries are the main reasons behind the inflation variability they sustain. But this explanation leads to a much deeper and fundamental question, which is why countries differ on the way they conduct fiscal and monetary policies. One of the many attempts that have been made to answer this question is based upon the idea that structural features of a specific economy determine its government's ability to collect taxes. Chelliah, Baas, and Kelly (1975), for example, provide evidence that countries with larger per capita nonexport income, more open to trade and with larger mining but smaller agricultural sectors have, on average, a higher "taxable capacity" or ease of collection. This view implies, among other things, that the countries' ability to tax is technologically constrained by their stage of development and by the structure of their economies (e.g. size of the agricultural sector in GDP), and as tax collecting costs are high and tax evasion pervasive, countries might use the inflation tax more frequently. One interpretation is that governments in poor countries might find it optimal to rely more heavily on seigniorage instead of output taxes to finance their expenditures. In this connection, the Theory of Optimal Taxation (see Phelps, 1973, Vegh, 1989, Aizenman, 1992), according to which governments optimally equate the marginal cost of the inflation tax with that of output taxes, is consistent with the structural view of the determinants of inflation. Edwards and Tabellini (1991) and Cukierman, Edwards, and Tabellini (1992) fail to find evidence that this theory applies to developing countries. …

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