Political Stability and Economic Development

Analysing correlations between political stability and inflation, GDP

per capita growth, unemployment

BACHELOR THESIS WITHIN: Economics

NUMBER OF CREDITS: 15 ECTS
PROGRAMME OF STUDY: International Economics
AUTHOR: Ausrine Milasaite, Ivana Micic
Jönköping: May, 2022

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Bachelor Thesis in Economics

Title: Political Stability and Economic Development; Analysing correlations between

political stability and inflation, GDP per capita growth, unemployment
Authors: Ausrine Milasaite and Ivana Micic
Tutor: Paul Nystedt
Date: 2020-05-23

Key terms: Political stability, inflation, GDP per capita growth, unemployment

Abstract
The main aim of this thesis is to investigate the relationship between political stability,
inflation, unemployment, GDP per capita, and vice versa. Previously this question has been
studied in the relationship between political stability and each of these economic variables
individually. With this research we can analyse if the poor economic performance in some
countries is caused by unstable political institutions, that is why we find it important. Here we
are analysing and comparing all of the economical variables at the same time and analysing
which ones show the strongest relationships, or if the relationships are significant or not
significant. In previous studies, the measurements that were used for political stability were:
government changes, cabinet changes, index of economic freedom, or polity state. However,
in this paper, the political stability measurement used is the Political stability index and
Absence of Violence/Terrorism, which measures the likelihood that the government will be
destabilised. Additionally, differently, from previous studies, Granger causality is used to
understand causality between political stability and economic development variables.

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Table of contents

1. Background ……………………………………………………………..….. 4
2. Purpose…………………………………………………………………….….5
3. Literature review…………………………………………………………..…6
3.1 Political instability effect on inflation……………………………………..6
3.2 Political instability effect on economic growth……………………………7
3.3 Political instability effect on unemployment……………………………....9
4. Historical political background…………………………………………..….9
5. Data…………………………………………………………………………..14
6. Methodology…………………………………………………………………16
6.1 Phillips curve …………………………………………………………….16
6.2 Descriptive Statistics……………………………………………………..16
6.3 Linear Regression………………………………………………………...16
6.4 Fixed Effects Model……………………………………………………...17
6.5 Granger Causality………………………………………………………...17
7. Empirical results………………………………………………………….…18
7.1 Phillips curve……………………………………………………………..18
7.2 Pearson Correlation………………………………………………………19
7.3 Granger Causality………………………………………………………...20
7.4 Linear Regression…………………………………………...……………22
7.5 Fixed Effects Model………………………………………………….…..25
7.6 Discussion………………………………………………………………..27
8. Conclusion…………………………………………………………………...28
Reference List………………………………………………………………...…30
Appendix………………………………………………………………………...33

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 1. Background

Low political stability can be defined as the tendency of government collapse that could
happen because of civil conflicts or competition between political parties (Hussain, 2014).
Various economic variables, such as inflation, unemployment level, and GDP per capita
growth, are interconnected with political stability. The uncertainty associated with not stable
political conditions could reduce investment which would lead to slower economic
development (Alesina et al., 1996).

Some countries have low levels of income, however, economic policies alone are not able to
explain the reason that some countries have very low levels of GDP. In order for a country to
grow, good policies are necessary, but without good political and economic institutions,
long-term changes in income are not achievable.

The main reasons that drive high-risk violent conflicts in countries are a recent history of
violent conflicts, fragile political institutions, and low levels of GDP per capita(poverty).
Some other factors that tend to increase the risks of violent conflicts are ethnic dominance,
regional conflict zones, and inter-group inequalities. Nonetheless, poverty does have a direct
effect on the risk of conflict (Zachariah, 2005).

Different effects drive economic decline and stagnation. When there is an existing low level
of income, it directly affects the government's ability to gather taxes, correlating to the
inability of investing in infrastructure, healthcare, and education.

Economic stagnation is strongly correlated to the political stability of a country, and because
of it, economists regard low political stability to be harmful to economic performance. Due to
low political stability, countries may turn to often changing the different economic policies,
thus negatively affecting economic performance (Aisen et al, 2011).

As shown in Aisen and Veiga (2005) higher inflation is also affected by low political stability.
Due to the low political stability, horizons of governments are shortened which disrupts the
long-term economic policies needed for a better economic performance of countries.

However, the relationship is two-sided - the low political stability can be named as an
explanation for poor economic growth and as a consequence of it.

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In this research we will highlight the political stability effects on the mentioned economic
variables: inflation, GDP per capita growth, and unemployment levels. Additionally, the
relationship will be tested the other way, on how the mentioned economic variables can affect
political stability.

2. Purpose

This research aims to test a correlation between political stability and various economic
development variables, such as inflation, interest rates, unemployment level, and GDP per
capita growth. The effects of political stability will be tested in various countries in Africa,
Asia, and Latin America. All of these variables will be tested in relation to the political
stability index and how the index affects the three variables, additionally how the economic
development variables affect political stability. This research will help expand the knowledge
on which variables are more affected by the political stability in various countries. The
countries chosen are from South/Latin America: Guatemala, Haiti, Nicaragua, Ecuador,
Brazil, Bolivia, Peru, Colombia, Mexico, Uruguay, and Costa Rica, from Africa: Congo,
Rep., Algeria, Uganda, South Africa, Ethiopia, Mauritania, Kenya, Tunisia, Botswana,
Mauritius, Ghana, and from Asia: Cambodia, Israel, Iran Islamic Rep., Iraq, Pakistan, Brunei
Darussalam, Mongolia, Qatar.

There are a few reasons for picking this research question. Firstly, political stability and
economic growth are strongly interdependent, because a country with unstable politics is
concerning for potential investors, and a poor economic performance leads to governmental
collapses and political unrest. Each country itself is different and has unique conflicts and
unique economic crises. However, this paper aims to analyse how political stability can affect
inflation, unemployment level, GDP per capita growth, and the other way round. This can
add additional value to the previous research, since political stability can not only be seen as
an affect to the economic variables, but also as a consequence of the economic development
variables. Therefore, this paper analyzes countries with rather high political stability from
three different continents, while also adding eight countries with a more stable politics itself,
such as Botswana, Mauritius, Ghana, Uruguay, Costa Rica, Brunei Darussalam, Mongolia,

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Qatar, with the purpose of finding how political stability affects the three economic variables.
The countries were picked by the political stability index provided by the World Bank.
Previous studies have been focusing on each of the economic variables separately, this paper
includes inflation, unemployment and GDP per capita in the same research, in order to
conclude which variable has the strongest correlation with political stability. With regards to
unemployment, previous research has been done on youth unemployment, however, in this
study, the unemployment for the entire population will be considered, which differs from
before. We are also using a different index for political stability that has not been used before.
Our research is targeting the countries with more developing governments, since the
consequences of a low political stability in these countries can be examined the most.

3. Literature Review

This paper investigates the correlation between political stability and economic variables.
However, previous papers are investigating political instability in relation to the economic
variables. That is why in the literature review the term used will be political instability.

3.1 Political instability effect on inflation

One of the main reasons behind inflation in different countries is monetary and fiscal policy,
however, the main question arises on what are the exact differences that each government
conducts fiscal and monetary policies (Aisen et al, 2005). The ability to collect taxes differs
in countries, and that is due because countries tend to be in different developmental stages
and have different structures of economies. However, when a specific country is more open to
trade, and additionally has a great mining sector, large per capita non export income, but not
as large agriculture sector, then the government has a rather easier way of collecting taxes.
Because tax collection tends to be costly and tax evasion pervasive, governments might turn
to the usage of the inflation tax more often.
If a country is poorer, its government more often turns to seigniorage (which is the face value
of money and its cost of producing it), instead of output taxes for funding their expenditures.

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A theoretical model was developed by Cukierman et al. (1992), which determined the
equilibrium efficiency through political instability and polarisation, it resulted in the
combination of tax revenues and seigniorage that governments were using.
As this paper also covers countries in Latin America, back in 1987 Paldam picked eight
countries in Latin America and the study has been developed on the relationship between
political instability and inflation in those countries. Through theoretical studies and
examinations of the data, it has been found this relationship works both ways. The main
hypothesis is the responsibility hypothesis, in which the citizens would hold the governments
responsible for various economic outcomes. It is seldom that a weak government resists the
demand for public expenditures, and then in relation, it funds those expenditures with
inflation tax, where the causality between politics and inflation is present. In these situations
inflation tends to rise to high levels, making it more difficult for a weaker or unstable
government to resist the political pressures.
It has also been argued about the importance of institutions and their economic performance.
In case of volatility, growth, and crisis, Acemoglu et al. (2002) have stressed the great
importance institutions have on this, based on a large cross-section of countries. They argue
that when weak institutions, for example, do not have adequate mechanisms to ensure
property rights or enforcements, it leads to poor macroeconomic performance, which
correlates to the rise of bad macroeconomic performance. Therefore it can be concluded that
countries that have weak institutions, besides low growth, present the growth of inflation.
Weaker institutions have a harder time in creating better macroeconomic policies, therefore
the inability to enforce efficient tax systems, which all lead to more frequent use of
seigniorage and inflation tax as a basic and disposable source of revenue.

3.2 Political instability effect on economic growth

When it comes to the relationship between political instability and economic growth, the
connection is interconnected. That means that in the case of a country with an unstable
government, countries tend to be more cautious with investments which lead to slower
economic development. Looking at it from a different angle, when a country performs poorly
it leads to political crashes, unrest, and government collapses. Back in 1996, a study was
done on the relationship between political instability and economic growth by (Alesina et al.,
1996). A case study has been made in 113 countries in a time period from 1950-1982.

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The main result of this study is that with the government collapsing, the economic growth
was noticeably lower. This result was observed within all types of government changes, such
as ideology change or some power transfers. A more interesting result is that there was no
recorded difference in the economic growth whether the state had democracy or an
authoritarian type of government. The second result is that with continuous government
collapses, political instability tends to be consistent. An important argument is that there is a
strong uncertainty following economic decisions that include investments and production.
Therefore, when governments have a tendency to collapse, investors tend to be more cautious
about their investments or simply choose to invest elsewhere where the governments are
more stable.
Grossman (1991) had an analysis of revolutions, observing the correlation between political
instability and economic growth. In cases where rulers or authority in states are weak, or
there is a higher likelihood of the overthrow, there is a higher chance of political instability.
Since citizens are more prone to revolution, or engagement in protests, rather than in
incentives for more productive market activities. While in an instance when a
ruler/government is stronger, it is less likely that the citizens will engage in any revolution
against the government, therefore the only activities are in a line of productive market
activities, leading to more political stability and economic growth.
Studies have examined economic growth in specific government situations such as
democracies and dictatorships. When it comes to voting, voters tend to pay the most
attention to economic growth just before the elections. In non-democracies, if GDP per capita
and economic growth are growing, the likelihood of coups d’etat also decreases. In the case
of lower growth, it leads to dissatisfaction among the citizens and may lead to
anti-government political actions.
One of the popular opinions is that democracies are actually harmful to economic growth.
The basic idea behind this is that policymakers in democratic governments become
short-sighted before elections and focus on short-termed opportunistic policies that could be
used in favour of their reelection instead of focusing on policies that establish long-term
growth.
In conclusion, in studies that analysed the matter of whether dictatorship or democracy is
better for economic growth, the conclusion based on both theoretical and empirical is that
there is no significant relationship between democracy and economic growth. (Alesina et al.,
1996).

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3.3 Political instability effect of unemployment

Based on a paper done on the relationship between political instability and unemployment in
40 developing countries between 1991 and 2009 following conclusions have been drawn.
However, when education is involved, it directly corresponds to the magnitude of these
conflicts. In a country with highly educated individuals, there is a lower correlation with
political violence, however with a lower educated youth the opportunity for a riot or rebellion
is more likely than with those having higher education (Azeng et al. 2009). On the other
hand, democracy is not a variable that necessarily indicates higher political stability, because
their democratic institutions have a weak effect on this stability. When youth is faced with
inequality, the tension leads to conflicts, so the positive correlation between political violence
and inequality is common. Although, countries that succeed in having a good economy, are
less likely to be facing armed conflict outbreaks.
Even though there are many correlations between youth unemployment and political
instability; economic growth, inflation and instability are key features that when combined
have a direct effect on both unemployment and political instability. So unemployment itself
can not be viewed as a single variable that is directly related to political instability, but rather
as a result of a combination of variables mentioned above that lead to conflicts, riots, and
armed conflicts, that together increase the positive correlation to political instability.

4. Historical Political Background

In the 1990s, Latin America had a promising start to establish a more stable political and
economical environment. At the beginning of the 1990s, several programs were established in
hopes of encouraging macroeconomic stability. Policies, such as fiscal discipline, openness to
foreign direct investments, and improved property rights, displayed a change from
interventionist policies from the past. At the beginning of the decade, the installed policies
showed promising results - inflation diminished and the debt overhang was settled.
Additionally, social indicators, such as life expectancy and poverty became better. However,
things in Latin America changed after Mexico’s “tequila” crisis in 1994-95, which affected
not only Mexico but other major economies in the region (Belaisch et al., 2005). In December
1994 Mexican authorities faced a problem - a continuous drain on their reserves of foreign

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exchange. The government had to make a decision on how to fix this problem. One way of
stabilising the situation was to devalue the peso. By devaluing the peso they would reduce the
currency’s value in terms of dollars. The best way this solution could have helped is by
making Mexico’s exports more competitive and demonstrating to foreign investors that
Mexican assets were worthy, which would allow interest rates to decrease. Mexico chose this
option, however, it did not work out as they thought it would. On the other hand, the
government was one to blame for the failed devaluation of the peso. If the government
decides to devalue a currency, it is important to make the devaluation big - if not, there might
be expectations that there is more to come. This is where Mexico made a mistake - the first
devaluation was only 15%, almost half of what was suggested by the economists.
Additionally, the way the government acted was not helpful - it was very arrogant and
disinterested (Krugman, 2009). The financial crisis resulted in severe consequences - the
currency depreciated record amounts in one year, from 5.3 pesos per dollar to over 10 pesos
per dollar, from December 1994 to November 1995. Additionally, the GDP fell by over 6% in
1995, which resulted in the most drastic recession of a decade (Musacchio, 2012). The major
part of the “tequila” crisis was the diminishing capital inflows, due to foreign investors being
more risk-averse, these problems led to many vulnerabilities in major Latin American
economies. As a result, real GDP per capita numbers worsened and the improvement in the
social indexes diminished. Due to Mexico's “tequila” crisis, financial crises reappeared in
other countries, such as Brazil and Ecuador (1999), Argentina (2001), and Uruguay (2002)
(Belaisch et al., 2005).
Generally, there have been setbacks in the development in Latin America in the 1990s. The
countries in this region have seen troubles with increasing economic growth and avoiding
financial crises. Additionally, efforts to minimise income inequality and poverty have been
disappointing as well, which creates concerns about political sustainability and functionality
(Belaisch et al., 2005).
The concerning numbers can be seen from our datasets, used from worldbank.org. For
example, Mexico had the highest inflation percentage in 1996 compared to other years, with a
value of around 34%. In the same year, Mexico had the lowest political stability index of
around -0.92. High values of inflation can be seen in other Latin American countries in 1996,
such as Ecuador, Colombia, Bolivia, Brazil, and Peru. In countries such as Peru and
Colombia, the political stability index is similarly low, with values of around -1.06 and -1.64,
respectively, in 1996. In countries like Uruguay and Costa Rica, inflation was also high in
1996; 28.3% and 17.5%, respectively. However, in these specific countries, the political

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stability index stayed positive (above 0.6 in both countries), despite the concerningly high
inflation rates.

African countries have experienced some of the deadliest civil wars in the past decades.
Some of the most serious conflicts include Biafran War in Nigeria in the 1960s and 1970s, the
Congo Wars and Rwandan genocide in the 1990s, and the Ethiopian and Eritrean war in
1999-2000. However, even though these serious conflicts have come to an end, in the more
recent years the number of conflicts hasn’t decreased. Different types of conflicts increased
the political instability in Africa over the decades, the three different types are state-based
conflict, non-state conflict, and one-sided violence. There has been an increase in state-based
conflicts in recent years in Africa. State-based conflict is distinguished by the involvement of
the state government. The reason behind the escalation of the conflicts is the involvement of
IS in already pre-existing conflicts. Since 2007, the number of conflicts has increased
considerably, however, the number of countries participating in the conflicts has risen on a
smaller scale. For example, in 2007 10 countries were participating in 12 conflicts, and in
2017 - 18 conflicts, with 13 different countries participating, which means that the
geographical span has not expanded as much.
Non-state conflict implies that the organisations involved in the conflict are not related to the
state. Africa has the most non-state conflicts compared to the other regions, for example in
2017 there were around 50 non-state conflicts in the region. This is a great increase compared
to 2011, with only 24 conflicts. The reasons for these conflicts differ and might be difficult to
detect, however many countries that experience non-state conflicts, also experience
state-based conflicts. This can imply that already existing conflicts can create more conflicts -
countries already suffering from various conflicts have a higher possibility of conflict
outbreaks. This is logical, due to already unstable governmental issues, this leads to the
government being unable to resolve and manage the increasing number of conflicts.
The third type of conflict is one-sided violence. This occurs when there is violence against
civilians, organised by a group, that could be related to the state or not. There has been a
gradual increase in the number of one-sided violence conflicts since 2011. This type of
conflict is distinctive in Africa due to the high number of battle deaths. The highest number
was captured in 1994, during the Rwandan genocide, which caused more than 500000 deaths
(Bakken & Rustad, 2018).
The high number of different types of conflicts reveals the image of political instability in
Africa. Another way of illustrating the political stability of Africa is through coups d’etat -

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undemocratic regime changes or removal of the government powers. Although the number of
successful coups d’etat has been quite low in the 2000s, the number of attempted coups has
been higher, peaking in 1990. Additionally, Africa has been struggling with increasing
numbers of unfair elections (Bakken & Rustad, 2018).

For the past decades, some countries in Western Asia have been holding a large share of the
world's oil reserves. Additionally, this region has been a promising exporter of various
incremental supplies, since the 1940s. However, many countries in Western Asia are
politically unstable. The political issues have been evident for a long period - since the end of
the Second World War many crises have occurred, such as the Suez crisis in 1956, the
Arab-Israeli wars in 1967 and 1973, the Iraq-Iran war in 1980-1988, and the Gulf crisis in
1990. These conflicts have majorly and negatively affected the possible positive gains from
having such a large share of oil reserves (Mabro, 1990).
Some historical reasons can be named as the reasons for still ongoing political instability in
the Western Asia region. Similarly as in Africa, in Western Asia there exist political
boundaries, due to the imperial powers, in the time of the colonisation or when the
independence was gained. Some ethnic or religious groups have been divided between
several countries, which led to several conflicts. The new, artificially created independent
countries in Western Asia were involved in conflicts with neighbouring countries, due to the
ill-defined borders. The oilfields going through these ill-defined borders are also a reason
why the neighbouring countries go into conflicts. One of the examples of such conflict was
between Saudi Arabia and Abu Dhabi, over the Buraimi oasis in the 1940s.
Another reason for the political instability in Western Asia is underdevelopment. Similarly, in
some African countries, the labour forces are restricted and usually poorly trained with the
technological skills needed. Additionally, the political institutions are bureaucratic and very
disorganised. Even though some countries in Western Asia have large shares of the world’s
oil reserves, this hasn’t helped much with the development of the countries, it has created a
few extremely wealthy families, however, the majority of the regions are still
underdeveloped. The problem in this region is that the economies depend too much on the oil
reserves and not on more diverse products, which disrupts the constant economic growth
(Mabro, 1990).
The various and different problems prevent governments in this region from functioning
properly. Besides trying to fix the problems regarding the requirements of their foreign debt,
the governments are also faced with increasing countries’ poverty and social tensions.

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Additionally, the health and education systems are failing to keep up with the rapidly growing
population. An important cause of the political instability is related to the underdevelopment,
due to the increasing frustration of people because of continuing economic failures (Mabro,
1990).
The dictatorship also plays a major role in the emergence of political instability in Western
Asian countries. The establishment of dictatorship regimes have been implemented after the
Second World War when the USA favoured dictatorship implementation in the region to
prevent from Communist parties becoming too powerful. Accordingly, The USSR also
promoted the spread of communist dictatorships. Even though dictatorships could reach some
sort of internal political stability, it is not sustainable - the external pressures from society
lead to extreme consequences, like revolutions. Also, the immense power that the dictators
have, can negatively affect their judgement and intelligence. The exercise of power, that a lot
of dictators tend to end up in, can lead to reckless adventurism which can cause instability
(Mabro, 1990).
The problem of dictatorship is not only evident in Western Asia - dictatorship causes political
instability in already mentioned Latin/South America and Africa.
Additionally, besides our used political stability index, the corruption perception index can be
utilised to illustrate the political stability/instability of the chosen countries. Corruption is a
representation of nations' political institutions and their values and can be named a product of
inadequate government decisions. Corrupt acts can harm a country in different ways - it can
interrupt the execution of various policies and laws, it can hamper socioeconomic
development due to misallocated resources, additionally, it disregards basic human rights.
The problem of corruption is more serious in developing countries (Shabbir et al., 2016).
If we compare the political stability estimate and corruption perception index (retrieved from
“Transparency International, the global coalition against corruption”), we can identify some
similarities. In 2020, Iraq had the lowest political stability estimate value of the chosen
countries (-2.5) and it was ranked 160, with a low value of 21 within the corruption index. In
2020, Uruguay had one of the highest political stability estimates among the chosen countries
(1.05) and it was ranked relatively high - 21, with a high corruption perception index value of
71. Therefore, it can be said that the political stability estimates and corruption perception
index are related and illustrate similar information.

Summing up, previous papers have based the studies on how political instability affects
inflation, unemployment, and GDP per capita individually. Political stability was measured

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with different variables: government crises, cabinet changes, index of economic freedom,
polity scale, index of economic freedom, etc. When it comes to political stability and
inflation, it has been found that in the case of higher political instability, there are higher
inflation rates. For political stability variables, government crises and cabinet changes were
used as variables. The reason for this is due to often changes in government or cabinets, each
new one might have a different approach regarding inflation and therefore impose new
unstable political measures. Inserting an unstable political measure directly affects each
cabinet's length of stay in government, and results in often changes, leading to higher
inflation. With regards to economic growth, previous studies have found that in cases of high
political instability it reduces the economic growth of a country. It was found that political
instability has an adverse effect on total productivity growth. When it comes to the
relationship with unemployment, previous studies were focused on youth unemployment,
specifically the effect that youth unemployment has on political instability. Observations
were done in developed countries with high corruption and social inequalities. There is
significant evidence that youth unemployment is the cause of political instability. On the
other hand, this paper will not focus only on youth unemployment but include unemployment
for all ages in the analysis. This paper contributes with a deeper analysis of relationships
between political stability and economic development variables, using a different measure for
political stability and testing with additional models, such as Granger causality.

5. Data

The series for unemployment is a % of total labour force used as modelled ILO estimate. The
definition provided by the World Bank is: “The standard definition of unemployed persons is
those individuals without work, seeking work in a recent past period, and currently available
for work, including people who have lost their jobs or who have voluntarily left work.
Persons who did not look for work but have an arrangements for a future job are also counted
as unemployed.” (WorldBank, 2015a). Additionally, it is important to mention that: “The
series is part of the ILO estimates and is harmonised to ensure comparability across countries
and over time by accounting for differences in data source, scope of coverage, methodology,
and other country-specific factors.” (WorldBank, 2015a).

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The measure for inflation is likewise taken from the worldbank.org, with the definition of:
“Inflation as measured by the consumer price index reflects the annual percentage change in
the cost to the average consumer of acquiring a basket of goods and services that may be
fixed or changed at specified intervals, such as yearly.” (WorldBank, 2015a).

And lastly, the GDP per capita growth as annual %. The definition given by the
worldbank.org is: “Annual percentage growth rate of GDP per capita based on constant local
currency. GDP per capita is gross domestic product divided by midyear population. GDP at
purchaser's prices is the sum of gross value added by all resident producers in the economy
plus any product taxes and minus any subsidies not included in the value of the products.”
(WorldBank, 2015a).

The analysis of the research will be based on several countries from three regions -
Latin/South America, Asia, and Africa. The data will be used from 1996 (around) until 2020.
The data will be retrieved from the worldbank.org. The indicator for political stability data is
Political Stability and Absence of Violence/Terrorism: Estimate, retrieved from
worldbank.org. The definition provided is: “Political Stability and Absence of
Violence/Terrorism measures perceptions of the likelihood of political instability and/or
politically-motivated violence, including terrorism. Estimate gives the country's score on the
aggregate indicator, in units of a standard normal distribution, i.e. ranging from
approximately -2.5 to 2.5.” (WorldBank, 2015b). The reason we chose this indicator as a
determinant of political stability is because in previous research articles, indexes of economic
freedom and governmental crises were used as a determinant. Additionally, this is already an
estimation of the likelihood of political stability and terrorism, for example. It is convenient
to use since the estimation gives a specific score to every country. The indicator chosen is
calculated by occupying different variables retrieved from 31 different data sources obtaining
government perceptions based on surveys, non-governmental organisations, commercial
business information providers, etc (Kaufmann et al., 2010).

The time period that is included in this study is 1996-2020, this period was chosen to have
enough observations to test our hypothesis. Additionally when doing the two-way
fixed-effect model, we will separate it in two different periods from 1996-2008 and
2009-2020. This is done in order to investigate if there are any clear differences in the two
time spans.

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There were some limitations that we incurred, which is that some economic development
variable values were missing in certain years. To tackle this problem, the mean of the value
was taken, based on the equivalent values in the years between.

6. Methodology

6.1 Phillips curve

Firstly we will present the Phillips curve and analyse the relationship between inflation and
unemployment. ​The Phillips curve depicts the tradeoff between unemployment and inflation;
if one is higher, the other must be lower.The Phillips curve shifts due to two variables,
according to economists. The first is supply shocks, such as the Oil Crisis of the mid-1970s,
which popularised the term stagflation. The second factor is shifts in people's inflation
expectations (Greenlaw & Taylor, 2017).

6.2 Descriptive Statistics

To start the descriptive statistics, Pearson correlation will be presented. This correlation is
used to measure a linear association between variables. The values range between -1 and +1,
where negative values indicate that the increase of one variable is linked with a decrease of
another value and positive values indicate a tendency to increase or decrease one variable
together with another (Kirch, 2019).

6.3 Linear Regression

Additionally to the descriptive statistics, we will analyse the linear regressions and the
significance of the relationships, with the political stability index being the independent
variable. Linear regression is a statistical test used to interpret and specify the association
between the considered variables. The mathematical equation used for linear regression is, y
= mx + c, which illustrates the best fit for the association between two variables - dependent
(y) and independent (x). Additionally, the regression coefficient is used to entail the degree of
variability of y due to x (Kumari & Yadav, 2018).

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6.4 Fixed effects model

Panel data is used to observe the behaviour of variables across time. It is useful for checking
the variables that are unmeasurable or unobservable. In other words, it controls for individual
heterogeneity. The fixed effects model is convenient for evaluating the effect of variables that
deviate over time. When using the fixed effects model it can be speculated that something
within an entity could influence the outcome variables, therefore it had to be controlled for
(Torres-Reyna, 2011).

6.5 Granger causality

Besides the analysed Pearson correlation, linear regressions, and fixed effects model, to
check for causation this thesis will use Dumitrescu and Hurlin’s (2012) tests for Granger
causality. This approach is useful because it is applicable to heterogeneous panelized data
structures that recognize individual unit fixed effects. This specific panel causality test will
support our paper to understand the causality between political stability and economic
development variables. Additionally, this test acknowledges two heterogeneity classifications
- heterogeneity of causality and heterogeneity of the regression equation that is used to
examine Granger causality (Ganda, 2020).
In the fundamental research, Granger (1969) established a methodology for investigating the
causal interactions between time series. If there are two stationary series, xt and yt, the
following model can be adopted to check whether x causes y:
𝐾 𝐾
𝑦𝑡 = α + ∑ γ𝑘 𝑦𝑡−𝑘 + ∑ β𝑘𝑥𝑡−𝑘 + ε𝑡 with t = 1, . . . , T
𝑘=1 𝑘=1

If the previous values of x are considerable predictors of the present value of y, then x exerts
a causal impact on y. The following null hypothesis is used for the model:

𝐻0: β1 =... = β𝐾 = 0

In the case when the null hypothesis is rejected, the conclusion is that causality from x to y
exists. Additionally, the variables can be switched, to test the connection from the other
direction (Lopez & Weber, 2017).

17
An addition to the model was provided by Dumitrescu and Hurlin (2012):
𝐾 𝐾
𝑦𝑖,𝑡 = α𝑖 + ∑ γ𝑖𝑘𝑦𝑖,𝑡−𝑘 + ∑ β𝑖𝑘𝑥𝑖,𝑡−𝑘 + ε𝑖,𝑡 with i = 1, . . . , N and t = 1, . . . , T
𝑘=1 𝑘=1

This time the stationary variables xi,t and yi,t are the estimations for entity i in period t. To
test for the null hypothesis, Z - bar and Z - bar tilde need to be analysed. In this paper, we will
consider Z - bar, because the N and T are relatively large. The number of lags will be
specified by default, by the command xtgcause (single lag by default) (Lopez & Weber,
2017).

In the next section, we will discuss the results, which were estimated using STATA.

7. Results

7.1 Phillips curve

The outputs in the tables below will be analysed in the next parts.

Starting with the Phillips curve we have analysed the relationship between inflation and
unemployment. The result refers to Figure 4 in Appendix. At the beginning of the scatterplot ,
the data is spread out in the graph, however there is no trend that can be observed, since no
line can be drawn between the data. With the increase of inflation and unemployment, the
scatterplot flattens out showing a straight horizontal line between the data, meaning that there
is no correlation. Therefore, looking at the Phillips curve only, there is no correlation
observed between unemployment and inflation for our data set.

18
7.2 Pearson Correlation

Table 1. Pearson Correlation (political stability and inflation;political stability and GDP per
capita Growth; political stability and unemployment)

Political Inflation GDP per Unemploy

stability capita ment
Growth

Political Pearson 1.000

Stability Correlation

Level of sig.

N 750

Inflation Pearson -0.132* 1.000

Correlation

Level of sig. 0.0003

N 750 750

GDP per Pearson -0.035 1.000

capita Correlation
Growth

Level of sig. 0.340

N 750 750

Unemployme Pearson 0.033 1.000

nt Correlation

Level of sig. 0.368

N 750 750

Starting with the political stability index and inflation, the Pearson correlation coefficient is
-0.132. Since the sign of the correlation is negative, we can conclude that there is a negative
correlation between political stability and inflation. The relatively small value indicates that
there is small strength negative correlation between the two variables. As a result, if political
stability increases, inflation will decrease and vice versa. Additionally, we can say that there
is a statistically significant relationship between the two variables, since the level of statistical
significance of the correlation coefficient is 0.0003.

19
Political stability and GDP per capita growth Pearson correlation coefficient is also negative,
-0.035. The value is smaller, indicating that there is small strength negative correlation
between the two variables. Therefore, based on the Pearson correlation, if political stability
increases, GDP per capita growth will decrease and vice versa. This would be the opposite of
what other theories have found. Also, based on the high level of statistical significance of the
correlation coefficient (0.340) the relationship between the two variables is not statistically
significant.

Political stability and unemployment Pearson correlation coefficient is positive, 0.033,

indicating a small strength positive correlation between the two variables. As a result, if
political stability increases/decreases the unemployment level will increase/decrease together.
Similarly, as in the case with GDP per capita growth, the level of statistical significance of
the correlation coefficient is high (0.368), therefore the relationship is not statistically
significant.

7.3 Granger causality

The analysis will be based on the outputs in the table below.

Table 5. Granger Causality

H0 Z-bar p-value

Political stability does not cause Granger-cause inflation 5.037 0.000

Inflation does not Granger-cause unemployment 4.651 0.000

Political stability does not Granger-cause unemployment 3.064 0.002

Unemployment does not Granger-cause political stability 2.947 0.003

Political Stability does not Granger-cause GDP per capita growth 5.644 0.000

GDP per capita growth does not Granger-cause political stability 2.049 0.041

Sometimes it can be difficult to understand what exactly causes what and what are the
causations, therefore to address this, we will look at the results of Granger causality.

20
First, we will look at the relationship between political stability and inflation (and vice versa).
The value for Z - bar is 5.037 and the p-value given is 0.000. Since the p-value is very low,
we reject the given null hypothesis that political stability does not Granger-cause inflation.
The same result can be seen if we test the other way. The value of Z - bar is a bit lower, 4.651
but the p-value is the same. Therefore, we reject the null hypothesis that inflation does not
Granger-cause political stability.

Next, we test the relationship between political stability and unemployment. The value for Z -
bar is 3.064 and the p-value is lower than the significance level, thus we reject the null
hypothesis that political stability does not Granger-cause unemployment. If we test the
causality of unemployment on political stability, the value for Z-bar is similar, 2.947 and the
p-value is again low. Therefore, we also reject the null hypothesis that unemployment does
not Granger-cause political stability.

Lastly, we analyse the relationship between political stability and GDP per capita growth.
The value for Z-bar is higher, compared to the relationship with unemployment, 5.644 and
the p-value is very low. We reject the null hypothesis that political stability does not
Granger-cause GDP per capita growth. Looking the other way, the value for Z-bar is smaller,
2.049 and the p-value is higher, however, we still reject the null hypothesis that GDP per
capita growth does not Granger-cause political stability.

21
7.4 Linear Regression

In the Appendix, Fig 1., Fig 2., Fig 3., visualise the linear regressions between political
stability and inflation, GDP per capita growth, and unemployment. Fig 1. and Fig 2. look
relatively similar, having a more horizontal slope and Fig 3. the graph is more scattered.

For the next part, the outputs in the table below will be analysed.

Table 2. Linear regression (Political stability as independent variable)

Dependent variables

Inflation Unemployment GDP per capita

growth

Political Stability -1.152* 0.232 -0.169

(0.315) (0.257) (0.177)

Constant 6.838* 8.535* 1.743*

(0.328) (0.268) (0.184)

R-squared 0.018 0.001 0.001

No.observations 750 750 750

Standard errors are reported in the parentheses ; *indicates significance at the 5% level

First, the association between political stability and inflation will be checked.

Init=β0 + β1PSit + εit

H0: The relationship between inflation and political stability is not significant
H1: The relationship between inflation and political stability is significant

Based on the findings from the linear regression model, seen in Table 2, with inflation being
the dependent variable and political stability being the independent variable, it can be seen
that the p-value is very low, 0.000. The p-value is lower than the significance level of 0.05,
therefore we reject the null hypothesis and conclude that the relationship between inflation
and political stability is significant. The coefficient for political stability is -1.152, which

22
indicates that there is a negative correlation. This means that if political stability increases by
one unit, the mean of inflation will decrease by around -1.15.

Second, we test the relationship between GDP per capita growth and political stability.

GDPit=β0 + β1PSit + εit

H0: The relationship between GDP per capita growth and political stability is not significant
H1: The relationship between GDP per capita growth and political stability is significant

Based on the findings from the linear regression model, with GDP per capita growth being
the dependent variable and political stability being the independent variable, it can be seen
that the p-value is higher than the significance level of 0.05, therefore we fail to reject the
null hypothesis, thus we say that the relationship between GDP per capita growth and
political stability is not significant. The coefficient for political stability is negative, -0.169,
which means that again there is a negative correlation. If political stability increases by one
unit, the mean of GDP per capita growth will decrease by around -0.17. This result, although
having a small value of the coefficient, contradicts the previous studies, stating that higher
political stability leads to higher GDP per capita growth.

Lastly, we examine the relationship between unemployment and political stability.

Unit=β0 + β1PSit + εit

H0: The relationship between unemployment and political stability is not significant
H1: The relationship between unemployment and political stability is significant

Based on the findings and similarly, as in the regression with GDP per capita growth, the
p-value is again higher than the significance level of 0.05, thus we fail to reject the null
hypothesis, therefore we say that the relationship between unemployment and political
stability is not significant. The coefficient for political stability is positive, 0.232 which
indicates that there is a positive correlation. If political stability increases by one unit, the
mean of unemployment will increase by around 0.23.

For the next part, outputs in the table below will be analysed.

23
Table 3. Linear Regression (Political stability as dependant variable)

Dependent
variable

Political Political Political

stability stability stability

Inflation -0.015*
(0.004)

Unemployment 0.005
(0.005)

GDP per capita -0.007

growth (0.008)

Constant -0.321* -0.472* -0.419*

(0.046) (0.056) (0.037)

R-Squared 0.018 0.001 0.001

No. observation 750 750 750

Standard errors are reported in the parentheses ; *indicates significance at the 5% level

Since we are examining the correlations between political stability and the economic
variables from both ways, we will check the linear regressions when political stability is the
dependent variable. Based on Table 3, the p-values are exactly the same, as in the previous
linear regressions when the political stability was the independent variable, however, the
values of the coefficients are slightly different.
In the case when inflation is the independent variable, the coefficient of inflation is higher,
-0.015, as expected the sign of the coefficient is still negative.
When GDP per capita growth is the independent variable, the coefficient of GDP per capita
growth is also higher, -0.007.
Lastly, with unemployment being the independent variable, the coefficient is lower and still
positive, 0.005.

24
7.5 Fixed effects model

Firstly, the fixed effects model is used for the whole period: 1996-2020, therefore we have
750 observations. Inflation, unemployment, and GDP per capita growth are used as
independent variables and political stability is used as dependent variable. The equation for
the model in this scenario, takes the following form:

PSit=αi + β1Unit + β2GDPit + β3Init + εit

The outputs in the table below will be analysed in the next parts.

Table 4. Fixed effect model and Two-way Fixed effect models

Two-way Two-way Fixed Two-way Fixed

Fixed Effects Fixed Effects Effects Model Effects Model
Model Model until 2008 from 2009

Unemployment -0.040* -0.047* -0.041* -0.041*

(0.005) (0.009) (0.009) (0.015)

GDP per capita -0.003 -0.00004 -0.002 0.007

growth (0.003) (0.002) (0.002) (0.005)

Inflation -0.007* -0.008* -0.004 -0.011*

(0.002) (0.003) (0.003) (0.004)

cons -0.040 0.090 -0.006 -0.132

(0.047) (0.153) (0.119) (0.148)

Observations 750 750 390 360

R-squared (within) 0.101 0.168 0.189 0.155

Prob > F 0.000 0.000 0.001 0.002

Standard errors are reported in the parentheses ; *indicates significance at the 5% level

Firstly, based on Table 4, the F-test values were added at the bottom of the table. The test
should tell us whether or not country effects are equal to 0 and if not we reject the poolability
and assume that the fixed effects models are appropriate. Based on the results in Table 4, we
see that all the values are lower than 0.05, therefore we assume that the models are
convenient.

25
Based on the results in Table 4, the p-value for inflation and unemployment is lower than the
significance level of 0.05. Therefore, we can say that inflation and unemployment both have
a significant influence on political stability. However, the p-value for GDP per capita growth
is higher than the significance level. As a result, we can say that GDP per capita growth
doesn’t have a significant influence on political stability based on this model.
The coefficients for all three variables are negative as shown in “Table 6” indicating that
there is a negative correlation. If unemployment, inflation, or GDP per capita growth
increases by one unit, political stability will decrease by the coefficient values mentioned.
The within R2 value is 0.101, the value indicates how much of the variation of the dependent
variable (political stability) is indicated by the independent variables.

Secondly, the two-way fixed effect model is used with the same time period and the same 750
observations. Again, political stability is used as a dependent variable and the three economic
development variables (inflation, unemployment, and GDP per capita growth) are used as
independent variables. The reason for additionally including a two-way fixed effects model is
that, differently this time an option of “robust” was added to the model, to control for
heteroskedasticity. Also, year dummies are added as “i.year”. The additional component of
“time effects” 𝛾t is added, therefore the equation takes the following form:

PSit=αi + 𝛾t + β1Unit + β2GDPit + β3Init + εit

To start examining the results, the p-value for two independent variables, unemployment, and
inflation, is lower than the significance level of 0.05. It can be said that unemployment and
inflation have a significant influence on political stability. There is an opposite observation
for GDP per capita growth - it doesn’t have a significant influence on political stability.
The coefficients for all three variables are negative again, indicating a negative correlation,
with inflation having a similar value of -0.008 and the value for unemployment differs a bit,
-0.031. The coefficient value for GDP per capita growth is higher, -0.00004.
The within R2 value is higher compared to the previous model, 0.168, which means more
variation of the dependent variable is indicated by the independent variables.

Additionally, the two-way fixed effects model is used for two different periods: one from
1996 until 2008 and another from 2009 until 2020, to see if there are any visible differences

26
between the distinct periods. First, the outputs for the first period will be analysed, with 390
observations.

The p-value for unemployment is very low, indicating a significant influence on political
stability. On the other hand, differently than before, inflation doesn’t have a significant
influence on political stability, because the p-value is higher. In this case, again GDP per
capita growth doesn’t have a significant influence on political stability in this period.
Similarly, as before, the coefficients for all variables are negative, indicating a negative
correlation. The within R2 value is higher (0.189).
The outputs for the second period, from 2009 until 2020 will be analysed, with 360
observations.
During this period, the p-values for both unemployment and inflation are relatively low,
indicating a significant influence on political stability. Same as before, GDP per capita
growth’s p-value shows no significant influence on political stability. The coefficients for
unemployment and inflation are negative again, however, under this period the coefficient for
GDP per capita growth is positive, suggesting that there is a positive correlation. The within
R2 value is lower (0.155), compared to the period before 2008.
Looking at the two different periods, it can be seen that the relation between inflation and
political stability is significant in later periods but not in the first. It is an interesting result
and we have to be careful - it doesn’t necessarily mean that the difference between the two
estimates is statistically significant.

7.6 Discussion

The results concerning the relationship between inflation and political stability are correlated
with the theories from previous papers, stating that countries with more unstable governments
have higher inflation. Based on different models, the relationship between inflation and
political stability is significant. The coefficients show a negative correlation, which indicates
the similarities with studies done previously, stating that if political stability increases, the
inflation will decrease.
Different results can be seen concerning the relationships between political stability and GDP
per capita growth. Most of the results of the used models show no significance between the
two variables. Additionally, the sign of coefficients differs across models. This is not

27
corresponding with what other papers have found, stating that countries with more unstable
governments tend to have slower economic growth. However, looking at the Granger
causality, it can be seen that GDP per capita growth and political stability do correlate, thus
having causation with each other.
In the case of unemployment, some of the models identify significance between the two
variables and some don’t. The sign of coefficient also differs across models. However, some
models having positive coefficients contradict the results of previous research stating that
countries with higher unemployment have less political stability.
What we found are rather strong connections but also it is important to remember that the
effects between variables run in both directions. As a result, we have these complex
intertwined relationships between the mentioned variables.

8. Conclusion

When it comes to the fixed effects model, we have done four different analyses. In the first
two analyses we have included all the periods and analysed the fixed effects model and
two-way fixed effects model. Based on the p-value, inflation and unemployment indicates
significant correlation to political stability, while GDP per capita growth indicates a not
significant correlation. However, the coefficient for all three variables is negative, meaning
that there is a negative correlation.
The two-way fixed-effect model was used in two separate periods, from 1996-2008 and
2009-2020. In the first period from 1996-2008 we observed 390 observations. For
unemployment, the p-value was low indicating that there is no significant correlation between
political stability and unemployment. However, the p-value for inflation and GDP per capita
was significantly higher, indicating no significant correlation between political instability and
inflation and GDP per capita growth. The coefficient remains negative for all three variables.
In the second period from 2009-2022, there were 360 observations, and the results differ. P-
values for inflation and unemployment and inflation were low, indicating that there is a
significant correlation with political stability. GDP per capita growth correlation remains the
same, and it is not significant with political stability. Inflation and unemployment coefficient
remains also negative during this time period, while GDP per capita growth is positive,
indicating a positive relationship.

28
When it comes to the last test of Granger causality, both ways were tested for each
relationship. The null hypothesis has been rejected for every single one. The results show us
that political stability does Granger-cause inflation and vice versa, Granger-cause
unemployment and vice versa and Granger-cause GDP per capita growth and vice versa.
We believe that it is important for especially developing countries to not underestimate the
roles of governments for successful economic development because political stability plays a
role in development. In developing countries, we believe that policies should aim at
establishing feasible governmental mechanisms that will be beneficial in the long term, that
might reduce inflation and unemployment, and increase economic growth.

The suggestion for future research would be the analysis of each of these continents
separately. Then within this scope, separating countries into groups between those who are
more politically unstable and the more politically stable countries. However it might be
challenging to gather all of the data, since a lot of data for economic variables were missing
for many countries on these continents, which was the reason that we did not have more
countries included. When it comes to the history of the countries we have mentioned earlier,
we found it important to indicate what kinds of issues have occurred in the past decades, to be
able to justify the choice of the specific continents besides the political stability index.
However it is difficult to draw the exact conclusion between our results to the specific
countries because we have tested all of our observations at the same time, giving us an
overall conclusion for the relation between political stability and economic variables.
Therefore the suggestion above, with regards to testing specific continents/countries, could
give more specific results, and suggestions on which specific policies could be implemented.

29
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Appendix

Fig 1. Linear regression, inflation/political stability

Fig 2. Linear regression, GDP per capita growth/political stability

33
Fig 3. Linear regression, unemployment/political stability

Fig 4. Inflation and unemployment relationship

34