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Inflationary impact on public finance in emerging market economies

Economic stability is extremely sensitive to the structure of a political regime. Countries with inflation targets have the best price stability parameters, the most flexible exchange rates, the most independent central banks, and the most diverse economies among democracies, whereas countries with sovereign wealth funds have the best parameters among autocracies. To implement inflation targeting, macroeconomic policy institutions must have reached a particular level of maturity, which is proportional to their overall quality.

Emerging market economies have emerged as one of the world's most dynamic and economically significant divisions, given their importance in the global economy in terms of population and economic size. Hence, resolving these difficulties has significant economic, social, and political ramifications that extend beyond their national borders. Monetary policy is often the first line of defense against the various internal and external shocks to which these economies are now subjected. In an increasingly integrated global economy, where a combination of financial and trade ties bind domestic results to global causes, policymakers must pursue domestic stabilization mandates.

Both fiscal and monetary policy have inflationary impacts, and because their distributional effects differ, monetary policy cannot entirely counter fiscal policy. Hence, Political decisions influence fiscal and monetary policy, which is political. Inflation is primarily a political issue since it reflects spending and saving patterns that are affected by political choices. Emerging market economies confront several issues when it comes to creating monetary policy frameworks that promote monetary and financial stability. The rise of a genuinely global market economy, as well as the corresponding changes in monetary policy regimes around the world, has heightened the debate over how monetary policy affects the economy. The efficiency of a local Lender of Last Resort is harmed in emerging market economies due to financial vulnerabilities. As a result, the status of the credit market has an explicit connection to monetary policy.

Inflationary effects on the political economy, monetary funding, and income taxes are all alternatives. Hence, as the relationship between inequality and inflation weakens, the relationship between inequality and income tax revenue improves. In theory, high and uncontrolled inflation contradicts the universal objectives of sustainable growth and full employment, and a high consumer price index triggers inflation expectations and declines the economic agents’ confidence in financial policies. Inflation is a common element of the political economy, and it generally promotes the achievement of monetary policy objectives. The central bank shall, in particular, be prepared to act as Lender of Last Resort in the event of a Sudden Stop (of capital inflows) by effectively releasing international reserves.

Moreover, the chances for successful monetary policy in emerging market economies have worsened in recent years, as seen by much higher inflation rates. The presence of a public finance rationale for inflation requires that the tax system be inadequate. Furthermore, the pricing implies that price dispersion leads to higher inflation costs, although inflation indexation and its public financing relationship with the underlying inflationary regime should also be considered. Hence, a significant amount of inflation volatility is required to deflate nominal debt and restrict the build-up of real debt over time. In direct contrast to previous public finance-based literature on the inflation tax, the optimum quantity of money rule is followed to maximize private welfare even when distorting taxes need to be paid to raise revenue.

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