Oya Celasun

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.