The past decade has seen a substantial decline in inflation rates around the world. In particular, the developing economies have managed to significantly reduce inflation, in many cases from chronically high levels. This article summarizes recent IMF research on country experiences with inflation and disinflation, the determinants of the success of disinflation policies, the long-term causes of inflation, and new approaches to inflation modeling.
Since the start of the 21st century, the global economy has experienced inflation rates far below those during the previous five decades. Rogoff (2003) looks at this remarkable decline in global inflation and discusses a variety of different factors that might have contributed to it. These include significant improvements in central bank institutions and practices, as well as a growing public consensus that expansionary fiscal policies financed by money creation do not help address deep-rooted structural problems, but rather lead to high inflation.
Rogoff also argues that two byproducts of increased global competition—greater flexibility of prices and smaller markups of prices over costs—have reduced the potential gains from unanticipated inflation, and thus policymakers’ incentives to create such inflationary scenarios.
A longstanding premise is that large fiscal deficits lie at the root of chronically high inflation rates in developing countries. This view would suggest that the recent disinflation may have been partly driven by tighter fiscal policies. Catao and Terrones (2003) use a broad panel dataset to test this frequently claimed yet rarely proven relationship. They find a strong, nonlinear relationship between fiscal deficits and inflation in developing and high-inflation economies, but not among low-inflation advanced economies, thereby echoing earlier findings by Fischer, Sahay, and Végh (2002). In a study of 11 major disinflation episodes over the past decade, Celasun, Gelos, and Prati (2004) show that improvements in primary fiscal balances have played a major role in curbing inflationary expectations. In particular, strengthened primary balances seem to have sent strong signals about the commitment of governments to public debt sustainability, despite the fact that in some countries the stocks of public debt were increasing on account of large banking sector bailouts.
In a number of developing economies, the strength of commodity prices might have contributed to improvements in fiscal balances and declines in inflation. In many oil-exporting countries, for example, inflation rates have fallen despite continued rapid growth in monetary aggregates. Celasun and Goswami (2002) and Ohnsorge and Oomes (forthcoming) present evidence from Iran and Russia—two oil exporters—that appreciating exchange rates have reduced the demand for foreign currency denominated assets and increased the demand for domestic money, contributing to a reduction in inflation.
Increased mobility of capital across countries and increased levels of dollartization might also have had disciplining effects on fiscal and monetary policies in many developing countries. Dollarization reduces the effectiveness of inflation in deflating the real value of public debt. However, as argued by Reinhart, Rogoff, and Savastano (2003), dollarization does not necessarily create obstacles to monetary control. Some empirical evidence in a model of the inflation-output tradeoff in Loungani, Razin, and Yuen (2000) suggests that disinflation is likely to entail larger output losses in countries with more open capital accounts. This suggests that the higher expected costs of disinflation in the context of higher capital mobility could temper policymakers’ incentives to create an inflationary scenario in the first place.
With respect to the link between central bank independence and inflation, a study of Latin American and Caribbean countries by Jácome and Vázquez (forthcoming) finds a strong negative association between central bank independence and inflation. The result holds for three alternative measures of central bank independence, and after controlling for international inflation, banking crises, and exchange regimes. The result is also robust to the inclusion of a broader set of structural reforms that usually accompanies changes in central bank legislation, illustrating the complementarity between different reforms in achieving control over inflation.
A number of studies have tried to uncover the relationship between political institutions and inflation performance. Satyanath and Subramanian (2004) examine the determinants of nominal stability in the long run—including price and exchange rate stability—and find that the strength of democratic institutions, along with measures of conflict and openness, are the most significant determinants of long-run nominal stability. By contrast, a study by Hamann and Prati (2002) of the determinants of the short-run success of disinflation policies finds that weak executive authority, unfavorable external conditions, and a long history of inflation are associated with a higher chance of disinflation failure. This evidence suggests that the lack of strong democratic institutions tends to sow the seeds of inflation initially, but stronger democratic institutions may make it more difficult to eradicate inflation once it becomes entrenched.
Alongside the worldwide decline in inflation in recent years have come important advancements in modeling inflation dynamics using microfounded models, IMF research in this area has focused on the persistence of inflation, observed even in the absence of serially-correlated driving forces, such as during implementation of disinflation policies. Calvo, Celasun, and Kumhof (2002) propose a microfounded model of pricing that can generate inflation inertia without relying on backward-looking behavior by allowing price setters to establish pricing policies—rather than price levels—at infrequent intervals. The model can explain output costs associated with disinflation policies in an open economy. Cespedes, Kumhof, and Parrado (2003) study the macroeconomic implications of the same pricing mechanism in the case of a closed economy.
Calvo, GuillermoA., OyaCelasun, and MichaelKumhof, 2002, “Nominal Exchange Rate Anchoring Under Inflation Inertia”IMF Working Paper 02/30.
Catao, LuisA., and MarcoE. Terrones Silva, 2003, “Fiscal Deficits and Inflation,”IMF Working Paper 03/65.
Celasun, Oya, and MangalGoswami, 2002, “An Analysis of Money Demand and Inflation in the Islamic Republic of Iran,”IMF Working Paper 02/205.
Celasun, Oya, GastonGelos, and AlessandroPrati, 2004, “Obstacles to Disinflation: What Is the Role of Fiscal Expectations?”IMF Working Paper 04/111; also published in Economic Policy, 2004, Vol. 19, Issue 4, pp. 441–481.
Cespedes, Luis, MichaelKumhof, and EricParrado, 2003, “Pricing Policies and Inflation Inertia,”IMF Working Paper 03/87.
Fischer, Stanley, RatnaSahay, and CarlosVégh, 2002, “Modern Hyper and High Inflations,”Journal of Economic Literature,Vol. 40, No. 3, pp. 837–880.
Hamann, A. Javier, and AlessandroPrati, 2002, “Why Do Many Disinflations Fail? The Importance of Luck, Timing, and Political Institutions,”IMF Working Paper 02/228.
JácomeH., LuisI., and FranciscoVázquez, “Is There any Link between Legal Central Bank Independence and Inflation in Latin America and the Caribbean?”IMF Working Paper, forthcoming.
Loungani, Prakash, AssafRazin, and Chi-WaYuen, 2000, “Capital Mobility and the Output-Inflation Tradeoff,”IMF Working Paper 00/87; also published in Journal of Development Economics, 2001, Vol. 64, Issue 1, pp. 255–274.
Ohnsorge, Franziska, and NienkeOomes, “The Case of the Missing Inflation: De-Dollarization in Russia,”IMF Working Paper, forthcoming.
Reinhart, CarmenM., KennethRogoff, and MiguelSavastano, 2003, ”Addicted to Dollars,”National Bureau of Economic Research (NBER) Working Paper 10015.
Rogoff, Kenneth, 2003, “Globalization and Global Disinflation,”paper presented at a symposium by the Federal Reserve Bank of Kansas City, “Monetary Policy and Uncertainty: Adapting to a Changing Economy,”JacksonHole, WY, August.
Satyanath, Shanker, and ArvindSubramanian, 2004, “What Determines Long-Run Macroeconomic Stability? Democratic Institutions,”IMF Working Paper 04/215.
Sovereign Debt Structure for Crisis Prevention
By Eduardo Borensztein, Marcos Chamon, Olivier Jeanne, Paolo Mauro, and Jeromin Zettelmeyer
This Occasional Paper fosters the debate on potential innovations by asking how government debt could be structured to reduce the likelihood of crises, attain greater international risk-sharing, and facilitate the adjustment of fiscal variables to changes in domestic economic conditions. The paper considers recently developed analytical approaches to improving the structure of sovereign debt using existing debt instruments. It then discusses the pros and cons as well as practical challenges of a number of potential innovations, with a focus on proposals to introduce explicit seniority and GDP-linked instruments in the sovereign context.
Three key messages emerge from the analysis. First, the credibility of fiscal and monetary policies is a central prerequisite to buttress the willingness of investors to hold long-term local currency bonds. Credibility in turn depends on both the quality of institutions and a reputation for sound policymaking. Building such a reputation can take many years, but the combination of macroeconomic stabilization with institutional and structural reforms can accelerate this process.
Second, finding ways to protect private creditors from debt dilution in the sovereign context could reduce the cost of borrowing and increase market access for low-debt countries, as well as help prevent overborrowing and risky debt structures. Debt dilution occurs when new debt reduces the claim that existing creditors can hope to recover in the event of a default. Dilution has long been recognized as a problem in the corporate context, where it is addressed through debt covenants and explicit seniority. The study argues for further investigation of analogous innovations in the sovereign context.
The third message is that instruments with equity-like features, which provide for lower payments in the event of adverse shocks and weak economic performance, could help sovereigns improve debt sustainability and international risk-sharing. In particular, GDP-indexed bonds would provide substantial insurance benefits to both advanced countries and emerging markets, though they present substantial implementation challenges.
This study was issued as IMF Occasional Paper No. 237.