metadata: authors: 0: author: Domac,Ilker
1: author: Yucel,Mustafa Eray
count: World
docna: 0: docna: What triggers inflation in emerging market economics?
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Investment and Investment Climate,Economic Adjustment and Lending,Public Sector Economics,Inflation,Macroeconomic Management,Public Finance Decentralization and
            Poverty Reduction,Crime and Society
teratopic: International Economics and Trade
abstracts: cdata!: Emerging market economies (EMEs) have
            experienced a noticeable decline in inflation since the
            mid-1990s. Whether this stable price environment in EMEs is
            likely to endure and what kind of policies need to be
            followed to ensure price stability, however, still continue
            to be questions of considerable policy relevance. The
            authors investigate the factors associated with the start of
            24 inflation episodes in 15 EMEs between 1980 and 2001. They
            use pooled probit analysis to estimate the contribution of
            the key factors to inflation starts. Their empirical results
            suggest that increases in the output gap, agricultural
            shocks, and expansionary fiscal policy raise the probability
            of inflation starts in EMEs. Their findings also indicate
            that a more democratic environment and an increase in
            capital flows relative to GDP reduce the probability of
            inflation starts.
repnme: repnme: What triggers inflation in emerging market economics?
display_title: What triggers inflation in emerging
            market economics
listing_relative_url: /research/2004/08/5141948/triggers-inflation-emerging-market-economics
topicv3: Inflation m1326709 0870F4727ACED1CF8525815C00471347,Criminal Justice m1326993 1014,Fiscal Policy m1327144 445,Monetary Policy m1327609 444,Investment Entry m1504647 2544
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
no_of_pages: 25
author_keys: 0: author_key: 96290
1: author_key: 2107415
model_extractions: WPS3376

# **What Triggers Inflation in Emerging Market Economies?**

**Ilker Domaç**<sup>†</sup> **and Eray M. Yücel**<sup>‡</sup>

## **Abstract**

Emerging market economies (EMEs) have experienced a noticeable decline in inflation since the mid-1990s. Whether this stable price environment in EMEs is likely to endure and what kind of policies need to be followed to ensure price stability, however, still continue to be questions of considerable policy relevance. This study aims at investigating the factors associated with the start of 24 inflation episodes in 15 EMEs between 1980 and 2001. The paper employs pooled probit analysis to estimate the contribution of the key factors to inflation starts. The empirical results suggest that increases in the output gap, agricultural shocks, and expansionary fiscal policy raise the probability of inflation starts in EMEs. The findings also indicate that a more democratic environment and an increase in capital flows relative to GDP reduce the probability of inflation starts.

## **JEL** **_classification_** : E31; E58.

**_Keywords_ :** Inflation starts; emerging market economies; price stability; probit analysis.

World Bank Policy Research Working Paper 3376, August 2004 _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._

> † Corresponding author. World Bank. Email address: idomac@worldbank.org.

> ‡ Central Bank of Turkey **.** Email address: eray.yucel@tcmb.gov.tr.
# **1. Introduction**

Emerging market economies (EMEs) have experienced a noticeable decline in inflation since the mid-1990s. Average inflation in these countries has declined from triple-digit figures in the late 1980s to low single-digit figures by the end of 2001 once a few outlier countries are excluded. This marked decline in inflation in EMEs is attributed to a more favorable external environment and the implementation of more prudent macroeconomic policies arising mainly from public discontent with high inflation.<sup>1</sup> More specifically, evidence suggests that fiscal consolidation—a prerequisite for macroeconomic stability—was one of the key contributing factors to disinflation: fiscal deficits in EMEs were lowered by one-half from the levels that prevailed in the 1970s and 1980s (IMF, 2001). External developments also contributed to the decline in inflation mainly through two channels: (i) the fall in global inflation; and (ii) the decline in oil prices in the first half of the 1990s. In addition to these factors, institutional reforms such as the enhancement of central bank independence, structural reforms in trade, product, and labor markets along with the improved access to global capital markets were among the forces behind the noticeable decline in inflation in EMEs.

In view of the adverse consequences of high inflation (Bruno and Easterly 1998, Ghosh and Phillips 1998, and Khan and Senhadji 2000), the observed decline of inflation in EMEs is clearly a positive development. However, whether this salutary development of a stable price environment in these countries is likely to be permanent and what kind of policies need to be pursued to maintain price stability still remain questions of considerable policy relevance. The objective of this paper is to shed some light on these questions by investigating the factors associated with the start of 24 inflation episodes in 15 EMEs between 1980 and 2001. To this end, we rely on a cross-

> 1 IMF (2001).

2
country data set and employ pooled probit analysis to estimate the contribution of the key factors to inflation starts.<sup>2</sup> Some earlier research has examined the determinants of inflation in EMEs.<sup>3</sup> To the best of our knowledge, however, there has not been any empirical study investigating the contributing factors to inflation starts in the case of EMEs, which would enhance the ability of policy makers in these countries to pursue appropriate policy actions in a preemptive manner.

The empirical findings suggest that an increase in the output gap—above-trend real economic activity—agricultural shocks, and expansionary fiscal policy raise the probability of inflation starts in EMEs. On the other hand, the results indicate that a more democratic environment and an increase in capital flows relative to GDP reduce the probability of inflation starts in these countries.

The remainder of the paper is structured as follows. The next section provides a brief overview of the literature on the determinants of inflation in EMEs. Section 3 discusses the definition of inflation episodes and inflation starts. Section 4 presents the empirical framework and estimation results. Section 5 highlights the salient features of inflation starts, in view of the empirical findings. Finally, Section 6 concludes the paper by summarizing the policy implications.

# **2. Review of the Literature**

The nature of the mechanisms underlying the dynamics of inflation in EMEs has stimulated much discussion. A quick glance at the literature points to two different

> 2 Our approach is very similar to a recent study by Boschen and Weise (2003), which focuses on the OECD countries.  This study includes the following countries: Argentina, Brazil, Colombia, India, Indonesia, Israel, Korea, Malaysia, Mexico, Peru, the Philippines, South Africa, Thailand, Turkey, and Venezuela.  The selection of the countries is dictated by data availability for the period under consideration.

> 3 See, for instance Loungani and Swagel (2001) and Mohanty and Klau (2001) as well as the references therein.

3
explanations.<sup>4</sup> According to the first view, inflation is largely influenced by nonmonetary factors, most notably frequent supply shocks, which render the prediction of inflation a difficult task. Such shocks are likely to complicate the monetary transmission mechanisms by obscuring the role of demand side factors in the inflation process. The second view puts forth that non-monetary factors affect only the short-run path of inflation, while, in the long run, monetary variables determine the inflation rate. As a result, it is argued that the standard output gap model should offer a reasonable explanation of the inflation dynamics in EMEs. As was pointed out by Mohanty and Klau (2001), however, the reality for EMEs is likely to lie somewhere between the two competing explanations. With this in mind, we will highlight the main tenets of the relevant literature in the context of EMEs below.

The nexus between the fiscal deficits, monetary growth and inflation emerges as an important reason for sustained high rates of inflation.<sup>5</sup> In spite of the theoretical links, the empirical evidence concerning the link between fiscal deficits and inflation has been rather elusive. At the level of any particular country, it may be difficult to establish a clear short-term link between fiscal deficits and inflation. In fact, the correlation may be even negative during extended periods of time. Evidence suggests that the existence of a positive correlation in the long run is also not a clear-cut phenomenon (Agenor and Montiel 1999). For instance, Fischer et al. (2002) find that the relationship between the fiscal deficit and inflation is only strong in high inflation countries—or during high inflation episodes—but they find no obvious relationship between fiscal deficits and inflation during low inflation episodes or for low inflation countries.

> 4 The objective of this section is not to offer a thorough review of the literature.  Instead, it intends to highlight the pertinent issues for the purpose of this investigation.  Mohanty and Klau (2001) and Loungani and Swagel (2001) provide a comprehensive review of the relevant literature.

> 5 See, for instance, Dornbusch (1992) and Bruno (1993).

4
A recent study by Catão and Terrones (2001), however, was successful in relating long-run inflation to the permanent component of the fiscal deficit scaled by the inflation tax base, measured as the ratio of narrow money to GDP. Their findings suggest that a 1 percent reduction in the ratio of the fiscal deficit to GDP typically lowers inflation by 1.5 to 6 percentage points depending on the size of the money supply.

On time consistency, central bank independence has received a great deal of attention in the literature. It is argued that a lack of central bank independence can lead to succumbing to political considerations, thereby engendering a monetary policy looser than optimal. For instance, if there is a perception that pursuing expansionary monetary policy can increase output, politicians could put pressure on the central bank—say during the election period—to trade off a boost to growth against higher inflation. In fact, the IMF (1996) finds that inflation performance between 1975 and 1995 in industrial countries is negatively correlated with an index of central bank independence. However, the findings of this study also suggest that the same relationship did not hold over the same period for developing countries. This conclusion may be attributed to imprecision in the measurement of central bank independence arising from a divergence between _de jure_ and _de facto_ central bank independence in these countries.<sup>6</sup> Indeed, a recent study by Gutierrez (2003) explores the relationship between inflation performance and the level of independence of the central bank entrenched in the constitution as opposed to the _de jure_ independence established in the central bank law. Her results suggest that Latin American countries that entrench the independence of the central bank in the constitution tend to have lower inflation, even after controlling

> 6 Independence is typically assessed by evaluating the central bank’s founding legislation and its institutional structure.

5
for other factors.<sup>7</sup> Central bank independence, however, cannot, by itself, ensure the credibility of monetary policy, which hinges on the overall stance of macroeconomic policy. For example, if the fiscal policy is deemed to be inconsistent with the inflation target, credibility is impossible to attain, even with an independent central bank.

Evidence suggests that the significance of the exchange rate in the evolution of domestic inflation tends to be greater in EMEs compared to advanced economies.<sup>8</sup> In these countries, the pass-through of a depreciation into domestic prices could be much larger than the share of imported goods in the consumption basket would indicate. This is because an increase in the price of imports in the face of a depreciation would also affect inflation expectations. An increase in inflation expectations, in turn, would tend to depreciate the exchange rate as agents buy foreign currency to maintain purchasing power. In view of this feedback between the exchange rate and domestic prices, a country can easily fall victim to a vicious circle of depreciation and inflation.

Large supply shocks emerge as an important source of inflation in EMEs. As pointed out by Fischer (1981), supply shocks may have major macroeconomic implications for EMEs. Notwithstanding the nature of the shock—i.e., temporary vs. permanent—the size of the overall price impact hinges on the importance of the sector in question for overall consumer inflation. For instance, food and energy have a relatively larger share in the consumer price index (CPI) compared to advanced economies. Consequently, a marked increase in prices of these commodities not only raise short-run inflation owing to their high weight in CPI, but also can engender a sustained increase in the inflation rate if it raises expectations.<sup>9</sup>

> 7 Typically constitutions are better enforced than ordinary laws in view of their superior legal rank.  Furthermore, modifications generally required qualified majorities to make the constitution much harder to amend than a law.

> 8 Ho and McCauley (2003).

> 9 In this respect, it should be noted that if supply shocks are accommodated by monetary policy, they can lead to demand driven inflationary pressures.

6
Political determinants of inflation have also received considerable attention in the literature. Political business cycle models developed by Nordhaus (1975) and Lindbeck (1976) envision that central banks pursue an expansionary monetary policy in the period leading up to an election in order to increase the governing party’s chances for reelection. The empirical evidence on the political business cycle hypothesis is mixed. McCallum (1978) and Alesina (1988) reject the hypothesis. A recent study by Alesina and Roubini (1997) finds that while elections have no impact on output and unemployment, they do affect inflation.

There is very little empirical evidence on the implications of political regime type or other regime characteristics for inflation.<sup>10</sup> Concerning this issue, there appears to be two competing schools of thought: populist approaches and state-capture approaches. According to the former, politicians responding to public demands increase government expenditures by resorting to inflationary finance. The institutional characteristics of democracy—electoral competition, separation of powers, partisanship, and political fragmentation—in turn raise pressures on politicians to use inflation tax. In view of this conjecture, populist approaches assert that inflation is less likely if governments with consolidated, autonomous—even dictatorial—powers can avoid these pressures. State-capture approaches, on the other hand, contend that price instability is not a result of demand for inflationary financing by the public, but by incumbent politicians and their elite patrons, who receive private benefit from money creation. The proponents of this view argue that democratic accountability promotes price stability since the reliance on the inflation tax is eroded once elites encounter credible challenges to their authority.

> 10 See Desai et al. (2002) and references therein.

7
Two recent studies focusing on the determinants of inflation in EMEs are noteworthy to discuss briefly in this section. A study by Lougani and Swagel (2001) employs vector autoregressions (VARs) to study the experience of 53 developing countries between 1964 and 1998. They estimate VAR’s consisting of the following variables: (i) money growth and exchange rates; (ii) the output gap and a measure of the world business cycle; (iii) changes in the price of oil and non-oil commodities; (iv) past realizations of inflation. Their findings suggest that either money growth or exchange rate movements—depending on the ordering—explain two-thirds of the variance of inflation at both short and long horizons. Their results indicate that inflation expectations also play an important role in the inflation process in developing countries: past realizations of inflation explain between 10 and 20 percent of inflation movements. Overall, their findings suggest that cost shocks or the output gap are not significant factors affecting the evolution of inflation in these countries.

By contrast, Mohanty and Klau (2001), who study the experience of 14 emerging market economies in the 1980s and 1990s, find that exogenous supply shocks—in particular those to food prices—play an important role in the inflation process. Food prices typically account for a larger percentage of the CPI in emerging market economies than in industrial countries. Furthermore, food prices tend to be very volatile owing to the influence of weather and the presence of trade restrictions. Their results suggest that although demand factors, captured by the output gap and excess money, have significant impact on inflation, their unique importance cannot be established for all countries. Wage growth and exchange rate changes, on the other hand, appear to make important contributions to inflation volatility in many countries. Their findings also indicate that inflation persistence plays an important role in explaining both the average level of inflation and its variation.

8
# **3. Definition of Inflation Episodes and Inflation Starts**

Prior to proceeding with the empirical investigation, it is important to clarify the definition of inflation episodes and starts. To this end, we rely on Ball (1994) and Boschen and Weise (2003) and construct the trend inflation series by calculating the nine-quarter moving average of the quarterly consumer price inflation rate. Next, we turn to the determination of trough and peak dates of inflation, which are identified as dates at which trend inflation is lower (higher) than in the preceding and succeeding four quarters. An inflation episode is then defined as a period of time over which trend inflation rises by at least 1 percent from trough to peak and which is preceded by four or more quarters of stable or declining trend inflation.<sup>11</sup> In total, we capture 24 inflation episodes for which detailed information can be found in Appendix A (Figures 1 and 2).

Figure 1: Number of Inflation Starts per year <!-- Start of picture text --> 6<br>5<br>4<br>3<br>2<br>1<br>0<br>80 82 84 86 88 90 92 94 96 98 00<br><!-- End of picture text --> Following Boschen and Weise (2003), we define the start date for an inflation episode as the year following the year in which the trough took place. As can be seen from Figure 1, which depicts inflation starts, 17 out of the 24 inflation starts occurred

> 11 In the definition of an inflation episode, we require a 1 percent rise from trough to peak though Boschen and Weise (2003) employ a 2 percent threshold for the OECD countries. The rationale behind our choice of 1 percent rise is that emerging market economies included in this paper have experienced long lasting periods of high inflation and, as a result, a lower threshold—1 percent as opposed to 2 percent—seems to be more appropriate in capturing the periods of sustained increase in inflation. The fact that the average rise in inflation per quarter during inflation episodes in Boschen and Weise (2003) amounts to 0.36 percent, while the same figure in our case is 2.18 percent, supports this conjecture.  Nevertheless, the empirical results remain intact when we employ a 2 percent threshold in lieu of 1 percent.

9
before 1990. This indicates that roughly 3 out of every 4 episodes in our sample took place in the 1980s, the years of 1986 and 1987 witnessing the largest number of episode starts. Table 1 presents the summary statistics for the 24 inflation episodes. Over the full sample, the average length of inflation episodes is roughly 15 quarters and 21 of them last for more than 8 quarters. Average rise in inflation, from trough to peak, is about 26 percent. In Table 1, we decompose our sample into three periods: 1984-1989, 1990-1995, and 1996-2001. The first period captures the period during which access to global capital markets was relatively limited. For the 12 episodes ending this period, the average length and the rise in inflation are about 13 quarters and around 44 percent, respectively.

<u>Table1: Summary Statistics for Inflation Episodes</u>

|||E<br>|pisodes Ending<br>||
|---|---|---|---|---|
||Full Sample|1984-1989|1990-1995|1996-2001|
|Number of episodes|24|12|8|4|
|Length (quarters)|14.83|13.33|18.13|12.75|
|Initial inflation rate|9.82|10.99|9.62|6.71|
|Ending inflation rate|35.85|54.61|19.87|11.56|
|Risein inflation|26.03|43.62|10.25|4.85|

Note: Figures are average values over the respective periods. Inflation figures come from our series obtained through nine-quarter centered moving average process.

There are 8 episodes between 1990 and 1995 with an average length of 18 quarters and an average rise in inflation of roughly 10 percent. It is interesting to note that during this period, which is characterized by increased access to capital markets, the average length of episodes are longer but the rise in inflation is substantially lower when compared to the 1984-1989 period. For the 1996-2001 period, we have only four episodes. Average length of episodes is around 13 quarters, similar to that of the 19841989 period. Average rise in inflation, on the other hand, is noticeably lower, around 5 percent, compared to other periods. In the next section, we will present the empirical framework and estimation results for 24 inflation starts in 15 EMEs between 1980 and 2001.

10
Figure 2: Inflation Episodes in 15 Emerging Market Economies (1980-2001) <!-- Start of picture text --> Argentina Brazil Colombia<br>200 140 7<br>160 120 6<br>100<br>120 5<br>80<br>80 4<br>60<br>40 3<br>40<br>0 20 2<br>-40 0 1<br>1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000<br>India Indonesia Israel<br>3.5 9 50<br>3.0 8 40<br>7<br>2.5<br>30<br>6<br>2.0<br>5 20<br>1.5<br>4<br>10<br>1.0<br>3<br>0.5 2 0<br>0.0 1 -10<br>1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000<br>Korea Malaysia Mexico<br>6 2.4 25<br>5 2.0<br>20<br>4 1.6<br>15<br>3 1.2<br>10<br>2 0.8<br>1 0.4 5<br>0 0.0 0<br>1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000<br>Peru The Philippines South Africa<br>240 8 4.5<br>200 7 4.0<br>6<br>3.5<br>160<br>5<br>3.0<br>120 4<br>2.5<br>80 3<br>2.0<br>2<br>40 1 1.5<br>0 0 1.0<br>1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000<br>Thailand Turkey Venezuella<br>5 20 20<br>18<br>4 16<br>16<br>3 14 12<br>2 12 8<br>10<br>1 4<br>8<br>0 6 0<br>1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000<br><!-- End of picture text --> 11
# **4. Empirical Framework and Results**

We employ probit analysis to investigate the factors associated with the start of the above highlighted inflation episodes in 15 emerging market economies between 1980 and 2001. In the estimations, the dependent variable is a binary variable, which takes on a value of 1 if an inflation start took place in that country during that year and a value of 0 otherwise. We stack the data for each country and estimate the probit models using maximum likelihood.<sup>12</sup> The variables that we consider largely draw on the empirical specifications employed in previous studies.

Table 2 presents the probit estimates for the models included in our study. We report the marginal effect of the independent variables evaluated at the means of variables involved along with the z-statistic associated with the coefficient estimate. The first model that we consider, Model 1, includes output gap (GAP), the percentage change in food production index (FP) and the percentage change oil prices (OIL) with a view to study the importance of above-trend real activity and supply shocks for inflation starts in these countries.<sup>13</sup> The results point to a strong positive relationship between the output gap and inflation starts, lending support to the policy mistake hypothesis.<sup>14</sup> More specifically, the findings show that a 1 percent rise in GDP growth above trend increases the probability of an inflation start by 7.6 percent. The results also suggest that there is a statistically significant negative correlation between FP and inflation starts—a finding underscoring the importance of agricultural shocks in inflation starts. On the other hand, there is no evidence that oil price shocks triggered inflation episodes

> 12 Appendix B provides a detailed description of the data.

> 13 The results do not change when we consider the percentage change in oil prices in national currency instead of in U.S. dollars.

> 14 The policy mistake hypothesis puts forth that policies aimed at expanding real economic activity above its potential are associated with inflation episodes (Sargent, 1999 and Taylor 1992).

12
during the period under consideration. Indeed, the coefficient associated with OIL is negative though not statistically significant.

<u>Table 2: Probit Estimations for Inflation Starts</u><sup>a</sup>

|Independent Variables|Model 1|Model 2|Model 3|Model 4|Model 5|Model 6|
|---|---|---|---|---|---|---|
|CONSTANT|-1.381|-1.591|-1.497|-1.292|-1.374|-1.088|
||(12.191)|(10.370)|(7.808)|(5.424)|(6.614)|(4.153)|
|GAP|0.076|0.090|0.088|0.097|0.084|0.097|
||(2.418)|(2.916)|(2.922)|(3.011)|(2.804)|(3.005)|
|FP|-0.049|-0.051|-0.051|-0.058|-0.043|-0.051|
||(2.194)|(2.308)|(2.312)|(2.431)|(1.928)|(2.094)|
|OIL|-0.004|-0.004|-0.004|-0.004|||
||(0.955)|(0.914)|(0.948)|(0.861)|||
|DEMOC||||-0.052||-0.067|
|||||(1.512)||(1.834)|
|DURABLE|||-0.006||-0.007||
||||(0.891)||(1.031)||
|BS||-0.050|-0.048|-0.058|-0.058|-0.067|
|||(2.233)|(1.987)|(2.501)|(2.277)|(2.461)|
|CF|||||-0.077|-0.086|
||||||(2.785)|(2.900)|
|Log likelihood|-81.6|-79.2|-78.7|-77.7|-76.8|-75.12|
|McFadden R<sup>2</sup>|0.052|0.079|0.084|0.093|0.107|0.123|
|Number of observations (0/1)|306/24|306/24|306/24|301/24<sup>b</sup>|306/24|301/24<sup>b</sup>|

a Absolute values of z-statistics, calculated using the Huber/White procedure, are given in parentheses under the corresponding coefficient estimates.<sup>b</sup> Five observations are missing since the DEMOC variable for South Africa (1992 and 1993), Korea (1987), Peru (2000), and for the Philippines (1986) were indetermined.

Model 2 incorporates budget surplus as a percentage of GDP (BS) to assess the role of fiscal policy in inflation starts.<sup>15</sup> The results underline the important link between fiscal policy and inflation starts: a 1 percent rise in BS reduces the probability of an inflation start by 5 percent. The output gap and FP continue to be statistically significant with their expected signs for inflation starts in this specification.

> 15 The lack of data for the majority of countries considered did not let us to examine the effect of the government debt on inflation starts.

13
In Models 3 and 4, we attempt to assess the importance of political determinants for inflation starts. To this end, we employ two variables, namely DEMOC and DURABLE for which Appendix B provides a detailed explanation. The first variable is a measure for institutional democracy, while the second variable captures the durability of the regime in the countries involved. The empirical results suggest that both DEMOC and DURABLE are negatively correlated with inflation starts, though only the former variable is marginally significant. The contributions of BS, FP, and output gap to inflation starts still remain statistically significant with their expected signs in Models 3 and 4.

In view of the substantial increase in capital flows to EMEs particularly during the 1990s, we also consider the impact of capital flows in relation to GDP (CF) on inflation starts in Models 5 and 6. A priori, it is expected that this development should be beneficial for disinflation since an increase in CF would reduce the need for seigniorage.<sup>16</sup> The empirical results concerning Models 5 and 6 point that CF has a negative and statistically significant impact on the probability of inflation starts. Focusing on Model 6, the findings indicate that a 1 percent increase in CF reduces the probability of inflation start by 8.6 percent. Consistent with the findings in other models, an increase in the output gap raises the probability of inflation starts, while a rise in food production and budget surplus reduce the probability of inflation starts.

Moreover, the findings indicate that a higher democracy score reduces the probability of inflation starts: a 1 unit increase in the democracy score lowers the probability of an inflation start by 6.7 percent. The results seem to lend support to the

> 16 It should be noted that despite their obvious benefits—increased efficiency and a better allocation of capital, and associated transfer of technology—the inflows have generated concerns in view of their potential adverse impact on macroeconomic stability, the competitiveness of the export sector, and external viability.  Indeed, the inflows are viewed as a serious risk, which can fuel inflation and lead to an unsustainable real appreciation of the real exchange rate.  However, the link between the inflows and inflation is not straightforward; it is influenced by the recipient country’s economic objectives, exchange rate regime, institutional constraints, and, particularly, the causes and the composition of the inflows.  Consequently, this issue needs to be settled empirically.

14
state-capture view, which argues that strong, insulated governments are needed to prevent inflation.<sup>17</sup> As was explained previously, this approach contends that inflation does not stem from voters or consumers pressuring politicians to ease monetary or fiscal constraints, but rather, because, incumbents obtain private benefits from money creation and from public spending (which they can then channel to favored constituents).<sup>18</sup> Accordingly, the main challenge of price stability is to force accountability upon incumbents to limit their private accumulation of wealth.

In addition to the specifications presented in Table 2, we have experimented with the inclusion of the lags of the variables involved and considered other models incorporating money growth, broad money in relation to GDP, change in the exchange rate, excess domestic credit growth, openness, current account balance in relation to GDP, and the ratio of broad money to international reserves as well as their lags. These variables turned out to be statistically insignificant and, as a result, were not included.<sup>19</sup> This finding, however, does not necessarily imply that these variables were not important in individual episodes; it simply suggests that they did not have systematic effects in our sample of inflation episodes.

# **5. A Quick Glance at Inflation Starts**

In this section, we examine the contribution of the variables involved in triggering inflation starts. We derive the decomposition of these contributions, presented in Table 3, from Model 6 in which all of our key variables are statistically

> 17 This finding is consistent with Cukierrman et al. (1992) who find that seignorage is larger in more totalitarian countries.

> 18 See Geddes (1995) for more on this.

> 19 Furthermore, we have also considered the US budget deficit in relation to GDP (USBD) in all models presented in Table 6.  The estimated coefficient on this variable is negative and statistically significant, suggesting that an increase in USBD raises the probability of an inflation start in EMEs.  The inclusion of this variable does not change the main thrust of the results reported in Table 6, except for the variable DEMOC, which becomes statistically insignificant in the presence of USBD.  The results of these experiments are available upon request.

15
significant. The figures under the column labeled probability are the fitted values of probabilities of the inflation start and are defined as:

> where _F_ (.) , β _i_ , and _i_ are the cumulative density function for the normal distribution, the estimated coefficients from Model 6, and the index for the independent variables, respectively. These probabilities can be compared to a baseline probability, which is the fitted probability value when all the variables are set to their mean values over the full sample period.

each individual variable to the start of inflation episodes. The percentage contribution of variable _i_ for country _j_ in year _t_ is calculated as: Our approach to computing the contributions differs slightly from that of Boschen and Weise (2003) since we divide the contribution of each variable by the absolute value of the total contribution of variables considered to the index. The use of the absolute value operator in the denominator of Equation (2) enables us to obtain the percentage contributions with correct signs since the total contribution to the index can take negative values.

The numerator of Equation (2) is the product of the coefficient estimate of variable _i_ ,<sup>β</sup> _i_<sup>, and the deviation of</sup> _X i_ , _jt_ from the sample mean, ( _X i_ , _jt_ − _X i_ ) . In other words, the individual contribution of each variable is determined by the coefficient estimate and the deviation of the actual value of the variable from the full sample mean 16
at the year of the episode start. Percentage contribution of each variable to the index at each episode start is reported in Table 3, which presents the average probabilities and percentage contributions for the years of episodes.

Although it is rather difficult to generalize the salient features of inflation starts across countries, several brief comments are in order concerning the results presented in Table 3. In majority of the inflation starts—17 out of 24—the contribution of the output gap is positive, documenting the importance of the above-trend real activity in triggering inflation. This, in turn, suggests that in the case of 17 episodes the output gap at the start dates was higher than the full sample mean of this variable. The percentage contribution of DEMOC carries a negative sign in 16 out of 24 inflation episode starts, suggesting that in these episodes this variable reduced the probability of an inflation start. However, in the case of the remaining 8 episodes the DEMOC variable contributes positively to inflation starts since the democracy score is below the sample average.

In the case of the variable BS, the findings suggest that this variable lowered the probability of an inflation start only in the case of 12 episodes. Since BS has a negative coefficient estimate in Model 6, this implies that the budget performance in the remaining 12 episodes was worse than the full sample average. The results also indicate that the variable FP contributed positively to inflation starts in half of the episodes, while that of capital flows in relation to GDP appears to be positive in 21 episodes. The latter result, in turn, implies that inflation starts are associated with CF lower than the full sample average.

17
<u>Table 3: Relative Importance of Major Variables in Inflation Starts</u>

|||||Perc|ent Dueto<sup>b</sup>|||
|---|---|---|---|---|---|---|---|
|Country||Probability<sup>a</sup>|GAP|FP|DEMOC|BS|CF|
|A. EPISODES||||||||
|Argentina|1987|0.16|0.27|0.73|-0.19|-0.06|0.25|
|Brazil|1986|0.49|0.32|0.16|-0.03|0.41|0.15|
||1992|0.02|-0.51|-0.32|-0.24|0.04|0.04|
|Colombia|1984|0.03|-0.04|-0.37|-0.53|0.24|-0.30|
|India|1990|0.12|0.00|0.25|-0.28|0.62|0.41|
|Indonesia|1986|0.09|-0.23|-0.54|1.31|-0.03|0.48|
||1997|0.17|0.19|0.47|0.60|-0.27|0.01|
|Israel|1983|0.19|-0.07|-0.26|-0.24|1.99|-0.42|
|Korea|1986|0.16|0.36|-0.08|0.64|-0.35|0.43|
|Malaysia|1987|0.11|-0.27|-0.15|0.18|0.46|0.78|
|Mexico|1985|0.19|0.09|-0.11|0.45|0.35|0.23|
||1990|0.07|1.74|-1.52|1.67|-0.39|-0.50|
|Peru|1980|0.10|0.02|0.63|-0.15|-0.19|0.68|
||1987|0.16|1.15|-0.63|-0.08|0.28|0.29|
|Philippines|1983|0.20|0.04|0.56|0.51|-0.12|0.01|
||1987|0.16|0.41|0.40|-0.19|-0.11|0.49|
|South Africa|1984|0.10|1.47|-0.74|-0.16|0.21|0.22|
|Thailand|1986|0.20|-0.31|0.65|0.26|0.06|0.34|
|Turkey|1983|0.12|0.24|0.61|-0.12|-0.19|0.46|
||1987|0.17|0.61|0.33|-0.08|0.00|0.14|
||1990|0.06|5.45|-3.20|-2.54|-0.43|1.72|
||2001|0.15|-1.04|0.58|-0.20|1.36|0.29|
|Venezuela|1984|0.06|0.99|4.42|-2.34|-5.55|3.48|
||1992|0.06|2.58|-0.45|-1.01|-0.21|0.09|
|B. AVERAGES||||||||
||1980|0.10|0.02|0.63|-0.15|-0.19|0.68|
||1983|0.17|0.07|0.30|0.05|0.56|0.02|
||1984|0.06|0.81|1.11|-1.01|-1.70|1.13|
||1985|0.19|0.09|-0.11|0.45|0.35|0.23|
||1986|0.24|0.03|0.05|0.54|0.02|0.35|
||1987|0.15|0.44|0.13|-0.07|0.11|0.39|
||1990|0.08|2.39|-1.49|-0.38|-0.06|0.54|
||1992|0.04|1.03|-0.39|-0.62|-0.09|0.06|
||1997|0.17|0.19|0.47|0.60|-0.27|0.01|
||2001|0.15|-1.04|0.58|-0.20|1.36|0.29|

a Probability figures are the fitted values from Model 6. b Figures presented are the percentage differences between point probability estimate and the baseline probability, where the baseline probability = 1 − _F_ ( _X_ β) = 0.050.

18
# **6. Conclusions**

Following the dramatic decline in inflation in emerging market economies (EMEs) since the mid-1990s, safeguarding the stable price environment has emerged as one of the most important policy priorities. Existing studies have largely focused on the determinants of inflation in EMEs in lieu of the factors triggering the inflation episodes. With a view to enhance the ability of policy makers in EMEs to take appropriate actions in a preemptive manner, we investigate the factors associated with the start of 24 inflation episodes in 15 EMEs between 1980 and 2001 by employing pooled probit analysis. The empirical results show that an increase in GDP growth above trend, agricultural shocks, and expansionary fiscal policy raise the probability of inflation starts in EMEs. The findings, on the other hand, indicate that a more democratic environment and an increase in capital flows relative to GDP reduce the probability of inflation starts in these countries.

Policy implications of this investigation can be summarized as follows. First, our results document the importance of prudent fiscal policy in reducing the probability of inflation starts. In spite of the widespread view that fiscal policy is closely connected with inflation in many EMEs, the empirical evidence pertaining to this link has been rather elusive. In this respect, the findings provide the much-needed additional empirical support concerning the importance of fiscal discipline for maintaining price stability. Second, earlier research has been inconclusive in establishing a close link between inflation and output gap in the context of EMEs.<sup>20</sup> Based on our findings, however, the link between economic activity above trend and inflation starts in EMEs appears to be quite robust, suggesting that central banks in EMEs should closely monitor the current and future path of aggregate demand in the economy.

> 20 See, for instance, IMF (1996) and Lougani and Swagel (2001).

19
Third, the importance of agricultural shocks for inflation in EMEs has also been acknowledged in previous studies.<sup>21</sup> The fact that food accounts for a larger share of the consumption basket in EMEs and that food prices are subject to the vagaries of the weather complicates the conduct of monetary policy in these countries.<sup>22</sup> This is because the role of monetary policy is more lucid and its impact is more potent when inflation is mainly driven by demand shocks and when demand changes can be traced by indicators such as monetary growth or output gap. By contrast, the strong impact of agricultural shocks on inflation engenders questions about the appropriate target for policy. Moreover, in view of the relatively high weight of food in the CPI in EMEs, agricultural shocks not only increase short-run inflation, but also can generate a sustained increase in the inflation rate if it raises inflationary expectations. As a consequence, EMEs should endeavor to liberalize agriculture to reduce the volatility of food prices and central banks in these countries should make an effort not to accommodate such shocks as their accommodation can lead to demand-driven inflationary pressures.

Fourth, the negative association of inflation starts with capital inflows highlights the importance of creating a conducive environment in EMEs for ensuring a high quality of external financing. In fact, the movement away from more stringent exchange rate arrangements toward inflation targeting or some form of this monetary policy in EMEs renders the quality of external financing an important policy issue. In this respect, recent studies offer the following insights: (i) countries with less stable external financing encounter difficulties in using the exchange rate to weather external

> 21 See, for instance, Debelle (2001) and Mohanty and Klau (2001).

> 22 As noted by Debelle (2001), the share of food in the consumption basket is under 20 percent in Australia, while its share is around 50 and over 40 percent in the Philippines and Indonesia, respectively.

20
shocks; and (ii) flexible exchange rate regimes are viable in financially open economies provided external financing is not based on very volatile capital.<sup>23</sup> Finally, the negative association of the democracy indicator employed in this study, which mainly reflects the competitiveness of political participation, the openness and competitiveness of executive recruitment, and constraints on the chief executive, with inflation starts implies that a more democratic environment promotes price stability. This, in turn, underscores the significance of a more democratic environment for the preservation of price stability and efforts for greater democratization in EMEs.

> 23 See, for instance, Goldfajn and Olivares (2001).

21
# **Appendix A: Inflation Episodes**<sup>a</sup>

<u>Table A1: Inflation Episodes</u><sup>24,25</sup>

|Country|Trough Date|Trough Inflation (%)|Peak Inflation (%)|Peak Date|
|---|---|---|---|---|
|<br>Argentina|1986:3|19.88|165.60|1989:2|
|Brazil|1985:4|27.61|131.34|1989:2|
||1991:3|63.01|123.53|1993:2|
|Colombia|1983:4|4.02|6.88|1991:1|
|India|1989:1|1.47|3.25|1991:2|
|Indonesia|1985:3|1.11|2.18|1987:3|
||1996:3|1.73|8.51|1998:1|
|Israel|1982:1|21.45|45.68|1984:3|
|Korea|1985:4|0.52|2.17|1991:1|
|Malaysia|1986:4|0.10|1.18|1991:4|
|Mexico|1984:3<br>1993:4|12.48<br>1.96|24.30<br>8.29|1987:1<br>1996:1|
|Peru|1979:4|12.73|24.93|1984:3|
||1986:4|15.72|211.42|1989:3|
|Philippines|1982:2|1.66|7.56|1984:2|
||1986:2|0.27|3.82|1990:1|
|South Africa|1983:1|2.85|4.21|1986:1|
|Thailand|1985:1|0.27|1.53|1990:2|
|Turkey|1982:2|6.68|10.58|1984:4|
||1986:3|7.88|14.52|1988:4|
||1989:3|12.04|17.23|1996:4|
||2000:1|11.12|12.21|2000:4|
|Venezuela|1983:1|1.80|12.94|1989:3|
||1991:4|7.28|16.61|1995:3|

a As was explained in Section 3, the inflation figures presented in the table are the filtered values of actual quarterly consumer price inflation using a nine-quarter centered moving average process.

24 There were inflation episodes in Argentina, Colombia, Israel, Korea, Malaysia, Mexico, South Africa, and Thailand whose start date turned out to be before 1980 and, as a result, could not be included in the investigation. The lightly shaded areas in Figure 2 present some of these episodes, which commenced before 1980 and ended in the early 1980s.

25 We have also considered including Chile in our study. However, the evolution of the inflation rate in this country displays a significantly different pattern since Chile has reduced its trend inflation noticeably during the late 1970s and the early 1980s compared to the countries involved. On this ground, we have not included Chile in our analysis.

22
# **Appendix B: Data Definition and Sources**

INFLATION ≡ CPI inflation rate obtained from source b (line 64).

GAP ≡ Deviation of the real GDP growth from its trend, which is computed using Hodrick-Prescott filter with a smoothness parameter of 100. Annual real GDP growth figures are taken from source a.

FP ≡ Percentage change in the index of food production. Data on food production index is taken from source a.

OIL ≡ Percentage change in dollar price of oil obtained from source d.

DEMOC ≡ The democracy indicator. It is an additive eleven-point scale (0-10). The operational indicator of democracy is a weighted average of the scores of the competitiveness of political participation, the openness and competitiveness of executive recruitment and constraints on the chief executive, taken from source c.

DURABLE ≡ Regime durability. The number of years since the most recent regime change. The first year during which a new regime is established is set as baseline year and DURABLE is assigned the value of zero for that year. Each subsequent year adds one to the value of the variable, taken from source c.

BS ≡ Overall government balance expressed as percentage of gross domestic product, taken from source a.

CF ≡ Ratio of net private capital flows to gross domestic product, taken from source a.<sup>26</sup> The data set covering the period 1980-2001 was compiled from the following<sup>27</sup> sources:

- a. World Development Indicators, World Bank; b. International Financial Statistics CD-ROM of the IMF, Version 1.1.54;

- c. Polity IV Database; d. Federal Reserve Economic Data (FRED);

- e. IMF Country Staff Reports.

> 26 For Israel and South Africa the series are constructed by taking the ratio of the financial account—obtained from source b (line 78bjd)—to nominal GDP measured in USD, taken from source a. For South Africa, the financial account is proxied by the Net Errors and Omissions taken from source b (line 78cad) for the years 1980-1984.

> 27 Without undermining the integrity of our data set,  we had to resort to source e for the missing data points for the BS variable in few cases.

23