The Connection Between Political Stability and Inflation: Insights from Four

South Asian Nations

Ummya Salma1 and Md. Fazlul Huq Khan2
1AssociateProfessor, Department of Management Studies, Bangladesh University of
Professionals (BUP), Email: ummya.salma@bup.org.bd
2PhD. candidate, University of International Business and Economics, Beijing
Email: Fazlul.khan@outlook.com

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.

Keywords: Inflation, Political stability, DOLS, FMOLS.

1. Introduction

Political stability refers to the condition in which a country's government and political system are
resilient and not subject to sudden or disruptive changes. It is a state of governance characterized
by continuity, order, and the absence of significant political upheavals, such as coups, revolutions,
or frequent changes in leadership. Hurwitz (1973)stated that the absence of violence and absence
of structural change is a form of state stability.

Political stability is of paramount importance for both developing and developed nations, as the
trajectory of economic growth is heavily reliant on a secure political environment. An unstable
political climate breeds uncertainties that can dampen economic growth by discouraging
investment. Moreover, subpar economic performance can result in government inefficiencies and
political turmoil. (Alesina et al., 1996). Political stability often leads to the implementation of
sound economic policies. When a country has stable and effective governance, it is more likely to
adopt and maintain policies that control inflation.

Political stability can attract foreign investment and increase investor confidence. When investors
believe that a country is politically stable, they are more willing to invest in that country's
economy. This influx of foreign capital can stimulate economic growth and reduce inflationary
pressures.
The problem of inflation, especially in developing nations, remains a topic of interest for both
economists and non-economists. Inflation is the continuous rise in the overall price level, which
diminishes the purchasing power of consumers within an economy (Tran, 2023). It leads to higher
costs for goods and services and significantly affects various other economic factors. Inflation
happens when the amount of money and credit in an economy increases more rapidly than the
supply of goods and services. Most countries gauge inflation using the consumer price index (CPI)
and the gross domestic product (GDP) deflator (Salma, 2021).

Although there is some disagreement regarding the specific mechanisms and pathways through
which inflation manifests in the system, it is widely acknowledged that inflation is influenced by
three fundamental sources: (a) excess aggregate demand (b) cost push factors and (c)
Distributional factors (Durguti et al., 2021). When demand outpaces supply, it exerts upward
pressure on prices. Similarly, increased market power of oligopolistic domestic firms, rising unit
labor costs, higher prices for imported intermediate inputs, and occasional or systematic
shortages of productive resources. Such factors contribute to inflation by increasing production
costs. Prolonged conflicts can manifest in economic institutions and practices such as indexation
and systematic price, wage, and rent adjustments, introducing unpredictable fluctuations into
inflation trends. These factors collectively contribute to the dynamics of inflation within an
economy.

Some researchers identified that maintaining consistently low and stable inflation has been
associated with positive outcomes, including enhanced economic growth and development,
greater financial stability, and a reduction in poverty (Ha et al., 2019) since persistent high
inflation is consistently associated with subpar economic growth and the heightened risk of
financial crises (Mishkin, 2008).

This study aims to make a valuable addition to the existing literature, as the earlier literature did
not delve into the influence of political stability on inflation in the chosen countries. To identify
the long-term relationship between the variables, we employ the dynamic ordinary least square
(DOLS) and fully modified ordinary least square (FMOLS) estimation methods.

In addition to this introduction, the paper is structured into five sections. Section 2 provides a
review of the literature. Section 3 covers the data and research methodology. Section 4 presents
the empirical findings and discussions, while Section 5 offers conclusions and outlines policy
implications.

2. Literature Review

A nation's economic performance is influenced not only by economic factors but also by political
and institutional factors. Additionally, certain political and institutional variables are thought to
have a significant role in elucidating both the variations and commonalities observed in economic
outcomes across countries Governments can potentially misuse monetary policy by pressuring
monetary authorities to generate a monetary surprise to boost short-term output, leading to
increased inflation without any tangible real benefits (Telatar et al., 2010).

There is a widely held belief that excessive inflation volatility can be detrimental to the overall
economy (M. F. H. Khan, 2021). Nevertheless, despite this consensus, it is somewhat perplexing
that numerous countries have grappled with both high and erratic inflation. Conversely, most
developed nations have successfully maintained low and stable inflation rates.

Faruq (2023) identifies the factors that contribute to increased foreign direct investment (FDI) in
a country and figured out that political stability attracts more foreign direct investment (FDI)
which contributes to significantly lower inflation. Anjom & Faruq (2023) also reached a similar
conclusion that financial and political stability is key in containing inflation to a satisfactory level.

Barugahara (2015) outlined three ways in which political instability can impact inflation volatility:
(a) In countries marked by higher political instability, it is likely that tax evasion and the costs
associated with tax collection will be more significant, (b) Political instability can also lead to
reduced output and investment, resulting in a decrease in taxable assets and income. This can
lead to an increased reliance on inflationary measures. Furthermore, political instability may
contribute to larger fiscal deficits by reducing revenues and increasing public spending,
particularly in countries with less developed financial markets. These deficits can have inflationary
consequences (c) Political instability often hinders the effective implementation of coherent
policies, eroding the government's competence and reducing its capacity to absorb shocks. This
can ultimately lead to macroeconomic imbalances characterized by volatile inflation.

Researchers try to find the factors that reduced the inflation volatility. One of the factors is central
bank independence which reduces inflation volatility (Cukierman et al., 1992). In developing
countries that maintain fixed exchange rates, inflation levels and volatility tend to be lower
(Bleaney & Fielding, 2002). Some researchers also find that trade openness reduces inflation
volatility (Granato et al., 2006; Bowdler & Malik, 2017).

The majority of previous studies have aimed to establish a link between political instability and
inflation, with only a limited focus on the relationship between political stability and inflation.
Consequently, a positive correlation has been identified in studies examining the connection
between political instability and inflation. However, researchers have uncovered a negative
correlation when investigating the impact of political stability on inflation.

Political instability can influence inflation, and conversely, elevated inflation can also impact the
political stability of a country. Paldam (1987) explores the impact of inflation on political change
and the frequency of military regimes in eight Latin American countries from 1946 to 1984. The
findings of this study suggest a bidirectional causal relationship. On one hand, a higher level of
inflation corresponds to a greater frequency of military rule, even though military regimes are
relatively unstable. On the other hand, political issues can contribute to higher inflation rates.

A similar outcome was discovered by Aisen & Veiga (2008) in their study spanning 160 countries
from 1960 to 1999. They utilized a GMM estimator and observed that a higher degree of political
instability is correlated with greater inflation rate volatility.

A decrease in political instability leads to a reduction in inflation. However, the presence of

political freedom plays a significant role in shaping the connection between political instability
and inflation. In a study conducted by Telatar et al. (2010), the impact of political instability and
political freedom on inflation was explored. Their results indicate that reduced political instability
is associated with lower inflation levels, but this effect is primarily observed in developed and
low-inflation countries. However, when considering political freedom as a factor, political
instability emerges as a significant influencer of inflation even in developing countries. Moreover,
this influence is particularly pronounced in high-inflation countries.

Aisen & Veiga (2006) conducted a study examining the connection between political instability
and inflation across 100 countries from 1960 to 1999, employing the system GMM estimator. The
study's findings reveal that increased political instability is associated with higher inflation rates
and greater seigniorage.

S. U. Khan & Saqib (2011) established a positive correlation between political instability and
inflation through their analysis of the impact of political instability on inflation in Pakistan, utilizing
data spanning from 1951 to 2007. Similarly, Haider et al. (2011) delved into the effects of political
instability, governance, and bureaucratic corruption on inflation and growth in Pakistan. Their
findings indicate that increased corruption coupled with weak governance leads to higher
inflation and lower economic growth. They also note that poor governance and corruption
coincide with political stability during democratic regimes.

Nonetheless, political instability can have contradictory effects on inflation. Specifically, instability
in the political regime dimension tends to significantly elevate inflation, while instability in the
government dimension significantly decreases inflation. (Ghanayem et al., 2023).

Political stability may exhibit a negative correlation with inflation when the shadow economy
remains limited in size. In their 2017 study, Mazhar & Jafri (2017) examined whether the presence
of a shadow economy could diminish the impact of political stability on inflation. They utilized
data from 122 countries spanning the period from 1999 to 2007. The study's findings indicate
that a negative correlation between political stability and inflation is observed only when the size
of the shadow economy remains relatively small.

Similarly, Tran (2023) also examine the impact of political stability on inflation in the presence of
shadow economy in Southeast Asian countries during the period from 2000 to 2017. They find
that the higher level of the shadow economy contributes to the increasing inflation rate. However,
the more political stability leads to the lower level of inflation. In addition, the impact of political
stability on inflation rate really depends on the size of the shadow economy.

3. Research Methodology and Data

3.1 Model:

In this study, we investigate the impact of political stability on the inflation rate. We employ
Dynamic Ordinary Least Square (DOLS) and Fully Modified Ordinary Least (FMOLS) estimators on
a dataset comprising four South Asian countries for the period spanning from 2001 to 2021. The
equation used for this study is:
𝐼𝑁𝐹𝑖𝑡 = 𝛽0 + 𝛽1 𝑃𝑆𝑖𝑡 + 𝛽2 𝑇𝑅𝑖𝑡 + 𝛽3 𝐸𝐺𝑖𝑡 + 𝛽4 𝐺𝑁𝐸𝑖𝑡 + 𝛽5 𝐷𝐶𝑖𝑡 + 𝛽6 𝐵𝑀𝑖𝑡 + 𝜀𝑖𝑡

In this study, the variable "i" corresponds to countries, and "t" signifies time. The dependent
variable, denoted as "INF," represents the inflation rate, while the independent variable "PS"
stands for political stability. Additionally, the control variables include "TR" for trade openness,
"EG" representing the economic growth which is measured by log GDP per capita (LGDPP), "GNE"
for Gross National Expenditure, "DC" signifying domestic credit, and "BM" denoting broad money.

3.2 Source of Data:

In this study, we investigate 4 South Asian countries including Bangladesh, India, Sri Lanka and
Pakistan from 2001 to 2021. All the data are collected from World Development Indicators (WDI)
of World Bank. Table-1 recapitulates the variables used in this study.

Table-1: Description of variables and data source

Variables Acrony Description Data source

m
Inflation INF Inflation, consumer prices (annual %) WDI
Political stability PS Political stability index WGI
Trade openness TR Trade (% of GDP) WDI
Economic LGDPP Natural logarithm of GDP per capita growth WDI
growth (annual %)
 Gross national GNE Gross national expenditure (% of GDP) WDI
expenditure
Domestic credit DC Domestic credit to private sector by banks (% of WDI
GDP)
Broad Money BM Broad money growth (annual %) WDI

In this study, the dependent variable under consideration is inflation, while the independent
variable of interest is political stability. Additionally, we incorporate several control variables,
including Trade openness (Chhabra & Alam, 2020), Economic growth (Paul et al., 1997), Gross
national Expenditure (Kandil & Morsy, 2011), Domestic credit (Nwachukwu et al., 2014), and
Broad money (Moser, 1995).

Table 2 displays the descriptive statistics for the dataset in this study. The highest recorded
inflation rate is 22.564 percent, while the lowest is 2.135 percent, with an average of 7.247
percent. As for political stability, the mean value is -1.329, the standard deviation is 0.69, the
minimum value is -2.81, and the maximum value is 0.09.

Table-2: Descriptive Statistics

Variable Obs Mean Std. Dev. Min Max
INF 80 7.247 3.62 2.135 22.564
PS 80 -1.329 .69 -2.81 .09
TO 80 41.065 12.164 24.702 79.483
LGDPP 80 7.174 .633 6.011 8.387
GNE 80 105.782 2.718 99.06 113.686
DC 80 34.898 11.615 14.579 54.572
BM 80 15.365 6.22 6.525 49.983

INF: Inflation; PS: Political stability; TO: Trade openness; LGDPP: Economic growth; GNE: Gross national Expenditure;
DC: Domestic credit; BM: Broad money

4. Results
4.1 Cross- Sectional Dependence Test

Cross-sectional dependence is a common occurrence in panel estimation. Neglecting to account

for cross-sectional dependencies in regression can result in a loss of efficiency and produce invalid
test statistics in the estimation process. able 3 displays the test results, indicating that the null
hypothesis of no cross-sectional dependence is accepted, as the probabilities from all the tests
are greater than 5 percent. Nevertheless, for this study, we will utilize a panel unit root test.
Table-3: Cross-sectional dependence test

Test Statistic Prob.

Breusch-Pagan LM 5.777609 0.4486

Pesaran scaled LM -0.064199 0.9488

Pesaran CD 0.567777 0.5702

4.2 Panel unit root test:

We utilize the panel unit root test to assess stationarity and ascertain the integration order of the
variables employed in this paper. Specifically, we apply the Levin et al. (2002), Fisher (1932), and
Im et al. (2003) tests to determine whether the data exhibit stationarity at the level or after first
differencing. The results in Table 4 indicate that all variables are stationary either at the level or
after taking the first difference, as confirmed by all three tests.

Table-4: Panel unit root test

Variables Levin, Lin, and Chu Fisher IPS
I (0) I (1) I (0) I (1) I (0) I (1)
INF -1.32 -6.23*** 3.20*** - -2.01*** -
PS -0.53 -1.82** -0.84 15.58*** 0.55 -3.53***
TR -1.81** - -0.31 11.39*** -0.37 -3.93***
LGDPP -1.85** - 1.68** - -0.35 -3.24***
GNE -1.82** - 1.61** - -1.60 -4.85***
DC -3.02** - -0.17 7.91*** 0.46 -3.46***
BM -0.54 -4.81*** 3.64*** - -1.97** -
Notes: **, *** significant at 5% and 1% level, respectively.

INF: Inflation; PS: Political stability; TO: Trade openness; LGDPP: Economic growth; GNE: Gross national Expenditure;
DC: Domestic credit; BM: Broad money

4.3 Panel Cointegration Test

To investigate the presence of a long-run equilibrium relationship among the variables, we

employ various panel cointegration tests developed by Pedroni (1999, 2004), Westerlund (2005),
and Kao (1999). The findings are presented in Table 5, revealing the existence of a long-run
relationship between the variables. This is evident as the null hypothesis of no cointegration is
rejected at a 5 percent significance level.
Table-5: Cointegration tests results

Statistics

Pedroni
Modified Phillips-Perron t 2.2447**
Phillips-Perron t -5.4448***
Augmented Dickey-Fuller t -3.9693***
Kao
Modified Dickey-Fuller t -1.4971**
Dickey-Fuller t -1.6844**
Augmented Dickey-Fuller t -0.6223**
Unadjusted modified Dickey-Fuller t -6.9983***
Unadjusted Dickey-Fuller t -4.7751***
Westerlund
Variance ratio -2.9797 **
Notes: *, **, *** significant at 10%, 5% and 1% level, respectively.

4.4 Empirical findings:

In this study, we aim to examine the impact of political stability on inflation in four South Asian
countries. We employ Ordinary Least Squares (OLS), the Dynamic Ordinary Least Squares (DOLS)
estimator recommended by Kao & Chiang (2000), and the Fully Modified Ordinary Least Squares
(FMOLS) estimator technique proposed by Phillips & Hansen (1990) to assess the relationship
between political stability and inflation in these selected nations. The results from all three tests
consistently reveal a negative and statistically significant relationship between political stability
and inflation in these countries. In other words, when political stability is higher, inflation tends
to be lower, and vice versa.

Furthermore, our analysis indicates that an increase in economic growth and trade openness is
associated with a reduction in the level of inflation. However, there is a positive and statistically
significant relationship between gross national income and domestic credit provided to the
private sector by banks and inflation. In a similar vein, while there is a positive relationship
between broad money and inflation, it is not statistically significant.
Table-6: The impact of political stability on inflation

OLS DOLS FMOLS

PS -3.257*** -3.050* -3.983***

TO -0.066** -0.145** -0.003
LGDPP -0.382 -4.172*** -1.941*
GNE 0.603*** 0.631** 0.517***
DC 0.114*** 0.472*** 0.257***
BM -0.030 -0.102 -0.028

Notes: *, **, *** significant at 10%, 5% and 1% level, respectively.

INF: Inflation; PS: Political stability; TO: Trade openness; LGDPP: Economic growth; GNE: Gross national Expenditure;
DC: Domestic credit; BM: Broad money

5. Conclusion
This article presents an empirical analysis of the impact of political instability on inflation in
Bangladesh, India, Pakistan, and Sri Lanka. Utilizing a balanced panel dataset spanning from 2001
to 2021 and employing the DOLS and FMOLS estimation techniques, this study reveals several key
findings. Firstly, the results consistently demonstrate that political stability exerts a negative and
significant influence on inflation in these selected countries. In other words, when political
stability increases, inflation tends to decrease, and vice versa. Furthermore, the analysis
highlights that trade openness and economic growth have a negative and significant impact on
inflation. Conversely, gross national expenditure and domestic credit exhibit a positive and
significant influence on inflation. While previous studies have explored the relationship between
political stability and inflation to some extent, there is a notable scarcity of research that solely
focuses on this effect in the selected countries. Therefore, this study contributes valuable insights
to the field and can guide future research in this area.

The empirical evidence presented in this study underscores the importance of promoting political
stability in the region. Policymakers should take into consideration the observed link between
greater political stability and lower inflation when formulating policies. Additionally, fostering
trade openness and stimulating economic growth while curbing national expenditure and
domestic credit can be effective strategies for reducing inflation.
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