Political Instability, Inflation Tax and Asset Substitution in Burundi

Abstract

The paper shows that civil war in Burundi in the 1990s has provoked an unprecedented decline in government revenue. Both foreign aid transfers and revenue from domestic sources dried up, inducing the government to rely more on inflation tax. Using quarterly data covering the period from 1980:1 to 2002:4 to measure the sensitivity of money demand to inflation we find that the long-run semi-elasticity of inflation to real money in circulation trebled between the pre-war to the war period. The remarkable increase of the semi-elasticity reflects what is known in the literature as “flight from domestic currency,” whereby domestic currency is substituted for less liquid assets. By shedding light on the behavior of the demand for real money amidst persistent political and economic instability, this paper illustrates the limits of inflation tax as a dependable source of government revenue.