This paper focuses on internal and external factors which influence the inflation rate in developing countries. A monetary model of inflation rate, capable of incorporating both monetary and fiscal policies as well as other internal and external factors, was developed and tested on Iranian data. It was found that, over the long run, a higher exchange rate leads to a higher price and that the fiscal policy is very effective to fight inflation. The major factors affecting inflation in Iran, over the long run, are internal rather than external. However, over the short run, the sources of inflation are both external and internal.
The determinants of inflation rate in developing countries are extremely important for policy makers as when the causes of inflation are correctly specified the appropriate policy change can be easily diagnosed and effectively implemented. Inflation in a small-open economy can be influenced by both internal and external factors. Internal factors include, among others, government deficits, debt financing, monetary policy, institutional economics (shirking, opportunism, economic freedom, risk, etc.) and structural regime changes (revolution, political regime changes, policy constraints, etc.). External factors include terms of trade and foreign interest rate as well as the attitude of the rest of the world (sanctions, risk generating activities, wars, etc.) toward the country. The objective of this paper is to develop and test a model of inflation rate, which takes into account all of these factors. To the best knowledge of the author, no such study for developing or developed countries exists. The model is tested on Iranian data. The choice of Iran is based on the fact that it has witnessed several changes in policy regimes and undergone numerous exogenous shocks during the past two decades. This makes Iran an ideal case to test whether external or internal shocks or a combination of these shocks cause inflation.
The channels through which government deficits and debt financing influence inflation include the formation of capital (crowding out effect), the monetization of debt and the wealth effect of debt. Institutional economics by reducing information costs can also reduce the inflation rate in a country. Furthermore, the change on terms of trade and foreign interest rates can influence the inflation rate in a country for which the economy is heavily dependent on imports and foreign financing of its debt. This is particularly important for developing/emerging countries.
The model used in this study is an augmented version of the monetarist model which, contrary to the existing literature, is designed in such a way to incorporate both external and internal factors, which cause inflation in the country. Furthermore, since the model also incorporates government deficits and debt, we can test Sargent and Wallace's (1986) views that (i) the tighter is the current monetary policy, the higher must the inflation rate be eventually and (ii) that government deficits and debt will be eventually monetized over the long run.
The contribution of this paper to the literature is as follows. The model developed in this paper is unique in the sense that it is capable of taking into consideration both monetary and fiscal policies as well as debt management. Furthermore, the model allows external and institutional shocks to affect the inflation rate in the country. It was found that the model is successful in capturing the impact of both anticipated and unanticipated effects of fiscal instruments, i.e., deficits, debt and debt management and of monetary instruments on the inflation rate in an emerging country like Iran. Moreover, a policy toward a stronger currency is deflationary and most sources of inflation in Iran are domestic factors. Finally, it was found that Sargent and Wallace's view on a tight monetary policy leading to higher inflation over the long run does not necessarily apply to a country like Iran, which, at least officially, banned predetermined interest rates.
Section 2 gives a brief background and is followed by a section on the development of the theoretical model. Section 4 describes the data and the long-run empirical methodology and results. Section 5 is devoted to the short-run dynamic model for the country. Section 6 evaluates the impact of unanticipated domestic factors on the inflation rate. The final section provides some concluding remarks.
This paper focuses on internal and external factors, which influence the inflation rate in developing countries. A monetary model of inflation rate, capable of incorporating both monetary and fiscal policies as well as other internal and external factors, was developed and tested on Iran. The estimation results proved the validity of the model as it is unique in the literature. Therefore, the first contribution of this paper is the development of the model.
It was found that, over the long run, a higher exchange rate (lower value of domestic currency) leads to a higher price in Iran. So a policy regime that leads to a stronger currency can help to lower inflation. However, a higher money supply when it is anticipated does not lead to a higher price level, but an unanticipated shock in the money supply results in a permanent rise in the price level. So an unanticipated reduction in the money supply should be a powerful tool to reduce inflation in Iran.
It is also found that the fiscal policy is very effective in Iran to fight inflation as the increase in the real government expenditures as well as deficits cause inflation, but if the changes are unanticipated they cause the opposite effect. More interestingly, it was found, for the debt management policy, that a higher outstanding government debt, anticipated or unanticipated, is considered a higher asset (i.e., demand for real balances increases) over the long run. Therefore, a high debt per GDP is deflationary. As for the foreign financing of the government debt, we found no price impact when it is anticipated, but it has a positive effect if unanticipated. In general, we found the major factors affecting inflation in developing countries, at least for Iran, over the long run, are internal rather than external factors. For example, the foreign interest rate has a deflationary effect in Iran over the long run while imported inflation does not exist in that country.
The overall conclusion over the short run is that the sources of inflation are both external and internal factors. The external factors include the foreign interest rate and sanctions. The fiscal policy as an internal factor has been the most effective tool over the short run to fight inflation in Iran. The government debt financed externally, while reducing the price level over the long run, creates more uncertainty over the short run and causes the inflation rate to increase.
