The Nonmonetary Determinants of Inflation: A Panel Data Study

Abstract

This paper explains inflation performance in a sample of 47 industrialand transition economies during 1993.96 by looking at the incentivesthat policymakers have to inflate the economy and at the perceivedcosts of disinflation. After a brief literature review, panel-dataeconometric techniques are used to estimate the effect on inflationof several nonmonetary variables (such as the fiscal balance, thedegree of development of the government securities market, and theunemployment rate) as well as a number of factors that may potentiallyaffect the natural rate of unemployment, particularly in transitioneconomies (such as the private sector share in GDP, price liberalization,and trade liberalization). It also looks at some standard institutionaldevices to lower inflation, such as central bank independence andexchange rate pegging. The econometric results indicate a significanteffect of fiscal deficits on inflation, particularly (but not exclusively)in countries where the government securities market is not well developed.Other factors with a significant effect on inflation include relativeprice changes, central bank independence, the exchange rate regime,and the degree of price liberalization. There is only limited evidencethat other structural factors, such as those influencing the naturalrate of unemployment (and hence the .unemployment motive. for inflation),affect inflation performance. The degree of openness of the economyis also not significant, although this may reflect the inclusionin the sample of many of the countries that were formerly part ofthe Soviet Union.