Inflation Essay

Empirical literature examining the determinants of inflation has mostly viewed it as a monetary phenomenon. This viewpoint basically stems from Milton Friedman’s famous dictum that inflation is always and everywhere a monetary phenomenon. However, the conjecture of Friedman has recently come under attack. In fact, there appears to be virtually no correlation between money growth and inflation since the early 1980s. This leads to evolution of the argument known as Fiscal Theory of Price Level (FTPL). To capture the nonmonetary aspects of inflation, a number of economists investigate the main political, institutional and economic determinants of inflation across countries and over time. For instance, Aisen and Veiga (2006) conclude that political instability leads to higher inflation. Their study reveals that an additional government crises and a cabinet change which are used as proxy for measuring political instability raise inflation rate by 16.1% and 9.1% respectively. In another study, Aisen and Veiga (2008) extend their work to further analyze the effect of political instability, social polarization and the quality of institutions on inflation volatility. They argue that politically unstable and socially polarized countries with weak institutions are more exposed to political shocks that result in discontinuous monetary and fiscal policies which in turn result in higher inflation volatility. The intuition is that rising inflation instability creates frictions on market which reduces economic efficiency and causes the prevailing price in the economy to deviate from the price which would otherwise have been determined in presence of stable price level. They also provide evidence that greater independence of the Central Bank leads...

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...uilibrium in public finances and distorted tax system particularly rely on seignorage. More specifically, fiscal policy has a significant effect on inflation in countries where government securities markets are less developed. In this connection, Telatar, Telatar and Ratti (2003) argue that term structure contains important information about future inflation and therefore can be used as a guide for initiating monetary policy to target price stability. According to their study, short-term borrowing at high interest rate stimulates re-borrowing in order to repay the debt services, thereby creating a viscous circle of high budget deficits and high interest rates. Since political weakness is one of the major reasons to this chronic and high budget deficit and inflation, the development of stable political institutions is therefore necessary in order to stabilize prices.