Tax cut-induced wage growth as a source of inflation in a dollarized economy : review of the case of Montenegro

Available studies suggest that fiscal policy measures aimed at increasing disposable income growth may have an impact on inflation. As inflation in Montenegro in 2022 was higher compared to the euro area, several studies were conducted to estimate the impact of external and domestic inflation factors. They identified a positive relationship between external factors (changes in import prices) and domestic factors (fiscal policy measures), as well as between these factors and inflation. However, they did not quantify the impact of any component, particularly of the fiscal programs implemented in Montenegro. This study aims to estimate the effects of fiscal policy programs on growth in disposable income implemented in 2022, which in turn led to increased household deposit growth. The empirical analysis based on estimated correlation coefficients between household deposits' annual change, import prices, and CPI in Montenegro (yearly data from 2014 to 2024) shows a strong positive linear relationship between changes in household deposits and CPI and also between changes in import prices and CPI, with a stronger correlation between change in import prices and CPI. This leads to the conclusion that deposit and import price growth influence inflation, with different impacts on its intensity. To estimate the impact of fiscal measures on inflation in Montenegro in 2022, we apply an accounting approach and use a dynamic mathematical model based on the quantitative theory of money. The study shows that inflation in Montenegro in 2022 was partly driven by household deposit growth, influenced by wage growth (in the part where wages grew above productivity growth), which contributed to half of the rate of price growth. The growth in prices of imported products contributed the remaining half of the inflation. The increased disposable income led to growth in demand deposits and time deposits of the households (up to one-year time deposits may be used as transaction money) which, according to the quantitative theory of money, led to price growth as it was not followed by similar production growth. During the same period, net public debt increased, which was associated with declining reserves financed through external borrowing in earlier periods, explaining the source of money supply growth. This study contributes to the literature by offering an additional approach to analyzing short-term inflation sources in dollarized countries during a short period or after specific fiscal instruments have been implemented. The accounting approach, combined with a mathematical dynamic model, provides the opportunity to investigate inflation determinants in more detail, giving a more in-depth view than the analysis conducted by applying the standard econometric models.