Fundamentals

Inflation and Institutional Crisis: How They Reinforce Each Other

By Daniel Sardá · Published on August 31, 2026

9 min read1,872 words

Inflation and institutional fragility can reinforce each other through public finances, credibility, and contracts, but the relationship is not automatic.

When money rapidly loses value, an ordinary decision such as setting a price or accepting payment becomes a gamble. But the uncertainty extends beyond prices: it also matters whether the public budget is credible, whether the central bank can fulfill its mandate, and whether a contract will still mean the same thing a few months later.

That proximity helps explain why inflation and institutional crisis often appear together. It does not prove, however, that either one always causes the other. An external shock can raise inflation in a country with strong institutions. A severe institutional crisis can develop without immediately producing a broad rise in prices.

The most useful way to understand the relationship is as conditional and bidirectional. Weak institutions can make it easier for a shock to become persistent inflation; in turn, prolonged high inflation can erode trust, contracts, and state capacity. Between these two ends lie specific fiscal, monetary, and legal decisions.

Key idea: the fact that inflation and institutional fragility coincide is not enough to prove causation. We need to identify the mechanism connecting them, the direction in which it operates, and the conditions under which it does so.

Two concepts worth defining

Inflation is a sustained, broad-based increase in the price level. It is not the same as a one-off rise in the price of gasoline, wheat, or rent, though such increases can trigger or transmit pressures to the rest of the economy. The distinction matters because the causes of inflation vary, and not all of them have an institutional origin.

By institutional crisis, we mean a deterioration in one or more basic capacities: applying policies consistently, upholding predictable rules, and making public commitments credible. It may involve conflict among branches of government, but it is not synonymous with every political crisis. The political dimension of an institutional crisis deserves a separate analysis; here, the focus is its connection to money and economic coordination.

Both phenomena exist by degree. A monetary policy mistake does not by itself make the entire institutional order a failure. Nor does moderate, temporary inflation necessarily cause a collapse in confidence. To speak of a feedback loop, we need to consider duration, scale, policy responses, and the quality of the rules.

A shock starts the problem; the regime determines its persistence

A drought, a war, a logistics disruption, or a surge in demand can raise many prices. At first, that increase reflects scarcity or an economic imbalance. The institutional question comes next: what makes that initial impulse fade or spread?

If households and businesses trust the authorities to maintain a coherent policy, they are less likely to interpret every increase as a sign of endless inflation. Contracts and wages may adjust without building in ever-larger increases. Public policy retains room to respond without promising the impossible.

When that trust is absent, time horizons shorten. Businesses expecting higher costs bring price adjustments forward; workers try to protect their income; lenders demand higher interest rates or shorter terms. None of these individual responses need be irrational. The problem is their combined effect: expectations of inflation can help prolong it.

Credibility is not a collective emotion that an authority can simply decree. It is built through results, understandable mandates, verifiable information, and constraints that make failure to follow through costly. Research from the Central Bank of Colombia shows that, for Colombia and under the study's model, a loss of credibility may require tighter monetary policy to achieve the same objective and may raise the cost of disinflation. Its estimated magnitude should not be transferred mechanically to other cases, but the mechanism is relevant: less credible promises reduce policy effectiveness.

Three channels connecting rules and prices

Institutional weakness does not enter the price index by itself. It operates through identifiable channels that can also interact with one another.

Fiscal pressure on the currency

A public deficit does not automatically produce inflation. It can be financed in different ways, and its effects depend on the context, productive capacity, demand for money, and creditor confidence. The risk grows when government financing needs persistently subordinate monetary policy and the central bank ultimately facilitates that financing.

In this scenario, the goal of stabilizing prices competes with fiscal urgency. If the public expects that urgency to prevail again and again, the expectation affects present decisions. So-called monetary financing can also function as an inflation tax: it reduces the purchasing power of money balances without going through the ordinary legislative process for taxation.

The institutional problem is not merely an accounting one. It includes opaque budgets, unfunded obligations, weak oversight, and the absence of durable agreements on spending and revenue. This is why a fiscal rule accomplishes little on its own if it can be circumvented or lacks legitimacy and oversight.

Monetary autonomy without arbitrary power

Central bank independence is intended to prevent the currency from being subordinated to immediate political needs. But independence does not mean absence of oversight. Sound institutional design combines a defined mandate, operational autonomy, transparency, published decisions, and accountability.

The IMF Central Bank Transparency Code treats transparency precisely as a complement to autonomy. From a liberal perspective, that combination is essential: limiting interference by the government of the day does not justify creating another opaque center of power. Constraints must apply both to the executive branch and to the monetary authority.

Expectations that feed into prices and contracts

Expectations do not explain every price increase, but they influence how increases spread. If the official target changes without explanation, statistics lose credibility, or policy measures contradict one another, people try to protect themselves with the information available. They adjust inventories, renegotiate wages, switch currencies, or shorten contract terms.

Useful distinction: a shock explains why prices began to rise; fiscal policy, the monetary response, expectations, and contracts help explain why they may continue to do so.

When inflation changes contracts

Money does more than enable purchases. It also provides a unit for comparing values and carrying agreements into the future. Unexpected inflation changes the real value of debts, wages, rents, and agreed payments. In some cases, it benefits the debtor; in others, adjustment clauses or variable interest rates shift the risk. What remains constant is the growing difficulty of knowing what is actually being promised in real terms.

Adaptation is possible through shorter contracts, indexation, the use of another currency, or frequent renegotiation. But adaptation comes at a cost. It requires more information, advice, and monitoring; it places a particular burden on people who cannot hedge; and it shortens the period over which two parties are willing to commit resources. The effects on purchasing power are only part of the damage. The coordinating function of contracts also weakens.

The historical case of Argentina examined by UCEMA illustrates how inflation, defaults, and legal uncertainty can accompany a loss of confidence in the currency and the financial system. It is a case, not a universal law. Its broader lesson is more cautious: if the rules for allocating losses change unpredictably, saving, lending, and investing for the long term become more difficult.

This is where a classic dimension of the rule of law comes into view. Legal certainty does not require every contract to remain frozen in the face of extraordinary circumstances. It requires any intervention to have a legal basis, limits, general criteria, and review. Without those safeguards, the response to inflation may deepen the very institutional crisis it was intended to contain.

The reverse direction: from prices to state capacity

So far, the path has run from institutions to inflationary persistence. The arrow can also point the other way.

First, inflation complicates the budget. When taxes are assessed and collected with a delay, the state may receive revenue with a lower real value. An IMF study documents how these lags can erode revenue, though the effect depends on tax-system design. At the same time, public-sector wages, pensions, procurement, and public works require adjustments. Planning and controlling expenditure become more difficult.

Second, distributional conflict increases. Inflation does not affect everyone at the same time or in the same proportion. Every adjustment to a utility rate, wage, tax, or contract determines who absorbs a loss. If decisions appear arbitrary, an economic dispute can become a dispute over legitimacy and equal treatment under the law.

Third, emergency responses proliferate. Price freezes, exemptions, multiple exchange rates, improvised subsidies, or contract changes may promise immediate relief. Some temporary measures may be justified in a specific crisis; the institutional risk emerges when they become discretionary, permanent, or immune from oversight.

Finally, a loss of trust reduces the authorities' ability to coordinate expectations. Once official announcements cease to be credible, stabilization requires more forceful and costly measures. This can heighten social resistance and fuel further exceptions. The loop closes: weaker institutional capacity makes stabilization harder, and failed stabilization erodes that capacity even further.

Caution: lowering inflation can halt part of the deterioration, but it does not automatically repair unreliable statistics, breached contracts, weakened oversight, or unsustainable public finances.

What breaks the cycle

No single institution can guarantee stability. The Latin American experience examined by the Inter-American Development Bank links improved macroeconomic performance to a combination of more autonomous central banks, fiscal institutions, and political constraints. This is regional evidence from a specific period, not a universal prescription, but it supports an important idea: institutions function as a system.

Breaking the feedback loop requires coherence across several fronts:

• a fiscal path that the public can understand and that does not routinely depend on monetary financing;
• a monetary authority with a clear mandate, operational capacity, public data, and accountability for its decisions;
• general rules for contracts, bankruptcy, and adjustment instead of improvised redistribution;
• reliable statistics and explanations that make it possible to evaluate both objectives and results.

These conditions limit power, but they also make its legitimate exercise possible. A government subject to a budget and legal oversight can better sustain long-term commitments. An autonomous and transparent central bank can resist immediate pressure without escaping public scrutiny. A predictable legal system allows risks to be allocated without promising that no one will suffer losses.

Neither monetary fatalism nor an institutional shortcut

Inflation can begin without an institutional crisis, and an institutional crisis can exist without high inflation. What matters is what happens after the initial shock. When deficits dictate monetary policy, promises lose credibility, and contractual rules become unpredictable, a price problem can become persistent. When that persistence reduces fiscal capacity, multiplies disputes, and normalizes exceptions, it can also weaken institutions.

The way out requires more than lowering a monthly index. It requires restoring people's ability to make plans: the budget must have credible backing, the monetary authority must explain its decisions and be accountable for them, and contracts must not depend on retroactive decisions. Lasting stability is not a choice between sound economics and sound institutions. It rests on recognizing that, without verifiable limits and credible commitments, neither can endure for long.