The Political Economy of Nominal Macroeconomic Pathologies

Recognizing that inflation and the macroeconomic policies that affect it can emanate from distributional conflicts in society, we examine the deep determinants of several nominal pathologies and related policy variables from a distributional perspective. We develop new instruments and use well-established existing instruments for these deep determinants and find that two deep determinants—societal divisions and democratic institutions—have a powerful and robust causal impact on nominal macroeconomic outcomes. Surprisingly, given the widespread attention accorded to the effects of populist democracy on inflation, democracy robustly serves to reduce inflation over the long term. A one standard deviation increase in democracy reduces inflation nearly fourfold. A similar increase in societal divisions increases inflation more than twofold. Our results are robust to alternative measures of democracy, samples, covariates, and definitions of societal division. It is particularly noteworthy that a variety of nominal pathologies and their proximate policy causes discussed in the recent macroeconomic literature, such as procyclical policy, absence of central bank independence, original sin, and debt intolerance, have common origins in societal divisions and undemocratic political institutions. IMF Staff Papers (2007) 54, 419–453. doi:10.1057/palgrave.imfsp.9450019