Democracy, Inequality, and Inflation

Abstract

Do democracies suffer higher inflation than non-democracies? We identify two competing hypotheses regarding the impact of democracy on inflation. In the "populist" approach, inflation is the result of public demands for transfers financed by the inflation tax, suggesting that electoral competition will increase inflation. In the "state-capture" approach, inflation is a result of pressure from elites who derive private benefits from money creation, suggesting that electoral competition may constrain inflation. We present a simple model that captures both ideas, and argue that the impact of democracy is conditioned by the prevailing level of income inequality. This claim is tested with data from over 140 countries between 1960 and 1999 using different dynamic panel estimation methods, including GLS, OLS, and to control for unobserved effects and the potential endogeneity of some independent variables, GMM techniques. We find robust evidence that democracy lowers inflation in low-inequality countries, but increases inflation in high-inequality countries.

JEL Classification: E31, P16