^*Arvind Subramanian was Assistant Director of the IMF Research Department when this paper was written. He is now a senior fellow at the Peterson Institute for International Economics and Center for Global Development, and Senior Research Professor at Johns Hopkins University. Shanker Satyanath is a professor in the Department of Political Science at New York University. We are especially grateful to Bob Flood, Simon Johnson, Edward Miguel, Dani Rodrik, Raghuram Rajan, and an anonymous referee for extensive comments on an earlier draft. We also thank Ajay Chhibber, Bill Cline, Tito Cordella, Barry Eichengreen, Josh Felman, Nurul Islam, Devesh Kapur, Aart Kraay, Ugo Panizza, Alessandro Prati, Rodney Ramcharan, Paul Ross, Martin Schindler, Guido Tabellini, Thierry Tressel, Xavier Sala-i-Martin, and participants at the IMF-World Bank seminar, at the Centre for Economic Policy Research (CEPR) conference on Institutions and Macroeconomic Stability at INSEAD, and at the Conference on the Political Economy of International Finance held at the University of Michigan for helpful discussions. Manzoor Gill, Ernest Sergenti, and Daniel Berger provided superb research assistance.

Abstract

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.