Thursday, March 17, 2005

Does political instability lead to inflation?

Politically unstable countries have a harder time taxing their citizens, and governments that expect to last for only a short time face lower costs of fiscally irresponsible policies. For both reasons, politically unstable countries are more likely to resort to inflationary finance. This IMF paper has some evidence:
...a higher degree of political instability, measured using several political and institutional variables, generates higher inflation rates and seigniorage. Higher numbers of cabinet changes or government crises measure not only political instability but also economic policy variability, since every new cabinet that takes over power might have a new set of preferences regarding inflation and unemployment levels. In addition, since every new government is inserted in a very unstable political and institutional environment, it is also very likely to be removed in a short period. These perverse mechanisms greatly affect the way governments conduct monetary and fiscal policies, generating higher inflation and seigniorage. We have also shown that the mechanisms indicated previously are more pervasive and stronger in developing and, especially, in high-inflation (above 50 percent) countries than in developed and low-inflation countries.

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