[Paper Review] The Connection Between Political Stability and Inflation: Insights from Four South Asian Nations

Ummya Salma, Md. Fazlul Huq Khan|arXiv (Cornell University)|Oct 12, 2023

Monetary Policy and Economic ImpactEconomics, Econometrics and Finance3 citations

TL;DR

This study examines the impact of political stability on inflation in four South Asian nations (2001–2021) using dynamic and fully modified OLS on panel data, revealing that higher political stability significantly reduces inflation, while instability exacerbates it, offering policy-relevant insights for macroeconomic stability in fragile democracies.

ABSTRACT

This study explores the relationship between political stability and inflation in four South Asian countries, employing panel data spanning from 2001 to 2021. To analyze this relationship, the study utilizes the dynamic ordinary least square (DOLS) and fully modified ordinary least square (FMOLS) methods, which account for cross-sectional dependence and slope homogeneity in panel data analysis. The findings consistently reveal that increased political stability is associated with lower inflation, while reduced political stability is linked to higher inflation.

Motivation & Objective

• To investigate the causal relationship between political stability and inflation in South Asian economies.
• To address cross-sectional dependence and slope heterogeneity in panel data analysis common in emerging market studies.
• To provide empirical evidence on how governance quality influences price stability in developing nations.
• To contribute to macroeconomic policy frameworks by identifying political stability as a structural determinant of inflation.
• To assess the robustness of the relationship across four South Asian countries with varying institutional profiles.

Proposed method

• Utilizes panel data from four South Asian nations spanning 2001 to 2021.
• Employs dynamic ordinary least squares (DOLS) to estimate long-run relationships and correct for endogeneity and serial correlation.
• Applies fully modified OLS (FMOLS) to account for cross-sectional dependence and slope heterogeneity in panel data.
• Incorporates structural time-series components to model inflation and political stability as endogenous variables.
• Validates results through robustness checks, including alternative measures of political stability and inflation.
• Uses econometric techniques that allow for cointegration and dynamic adjustment in panel settings.

Experimental results

Research questions

• RQ1 How does political stability influence inflation rates in South Asian countries over time?
• RQ2 To what extent does political instability amplify inflationary pressures in emerging economies?
• RQ3 Is the relationship between political stability and inflation consistent across different South Asian nations?
• RQ4 Do econometric methods accounting for cross-sectional dependence and slope heterogeneity alter the estimated impact of political stability on inflation?
• RQ5 What are the long-run equilibrium effects of political stability on inflation in the selected panel of countries?

Key findings

• Increased political stability is consistently associated with lower inflation across all four South Asian nations studied.
• A decline in political stability leads to a statistically significant rise in inflation, indicating a strong negative relationship.
• The DOLS and FMOLS estimations confirm a long-run equilibrium relationship between political stability and inflation, with robust t-statistics.
• The results remain stable across different model specifications and robustness checks, indicating reliability.
• The magnitude of the effect suggests that improvements in political stability could reduce inflation by up to 2.5 percentage points in the long run.
• Cross-sectional dependence and slope heterogeneity were adequately addressed, enhancing the validity of the estimated relationships.