Home » Research Blog » What we can learn from the “fiscal theory of inflation”

What we can learn from the “fiscal theory of inflation”

Fiscal policy is as important as monetary policy for inflation dynamics. Government debt has features similar to money and affects private wealth and prices. In particular, if monetary policy protects debt sustainability expansionary fiscal policy is inflationary and restrictive fiscal policy is dis-inflationary or deflationary. Moreover, high interest rates are inflationary and low interest rates are deflationary.

Leeper, Eric and Campbell Leith (2016), “Understanding Inflation as a Joint Monetary-Fiscal Phenomenon”, article for the Handbook of Macroeconomics, volume 2, January 3, 2016

The below are excerpts from the handbook article, focusing on the points that seem most relevant for financial markets at present. Headings, links and cursive text have been added.

On the current context of global public finances view summary here.

A broader perspective on inflation

It is always the joint behavior of monetary and fiscal policies that determine inflation and stabilize debt. While this point might seem obvious…it is easily missed in the classes of models and descriptions of policy typically employed in modern macroeconomic policy analyses…Expectations of fiscal policy are equally important to those of monetary policy in determining prices.”

Nominal debt is much like government-issued money: it is merely a claim to fresh currency in the future. The government may choose to raise taxes to acquire the requisite currency or it may opt to print up new currency, if currency creation is within its purview. Because the value of nominal [local-currency] debt depends on the price level and bond prices, the government [in conjunction with the central bank] really does not face a budget constraint when all its debt is nominal…”

“It is possible for monetary-fiscal policy mixes to permit nominal government debt expansions….to increase nominal private wealth, nominal aggregate demand, and the price level.”

When monetary policy “protects” active fiscal policy

“A…combination of passive monetary and active fiscal policies gives fiscal policy important effects on inflation, while monetary policy…ensures that actual debt…is stable by preventing interest payments on the debt from exploding and permitting surprise inflation to revalue government debt. In [this] regime…higher interest payments raise nominal wealth, increasing nominal aggregate demand and future inflation

On the basics of “financial repression”, a policy to secure cheap funding of governments supported by accommodative monetary policy, view post here.

“[In the simplest macroeconomic models]…even though the transitory fiscal expansion has no effect on real debt, higher nominal rates bring forth new nominal bond issuances that are proportional to the increases in the price level. Higher nominal debt coupled with higher interest on the debt increase interest payments that raise household nominal wealth in the future. Because future taxes do not rise to offset that wealth increase, aggregate demand and the price level rise in the future.”

“Evidently, if fiscal policies set surpluses exogenously, monetary policy is impotent to offset fiscal effects on inflation. And adopting a more hawkish monetary policy stance [in a conventional New Keynesian model] has the perverse effect of amplifying and propagating the effects of shocks on inflation.”

“Stronger and more persistent nominal interest rate increases transmit directly into stronger and more persistent growth in the nominal market value of debt. And persistently higher nominal debt keeps household nominal wealth and, therefore, nominal demand elevated, creating strong serial correlation in inflation and output. This internal propagation mechanism through government debt is absent from [a regime where fiscal policy is passive, which is what most conventional theoretical macroeconomic models assume].”

Moral hazard and debt stabilization bias

“When long-maturity government debt is outstanding, it is always optimal to stabilize debt partly through distorting taxes and partly through surprise changes in inflation and bond prices… It is the surprise change in the path of inflation that occurs over the life of the maturing debt stock that reduces the real value of debt…How important inflation is as a debt stabilizer…depends on…the maturity structure of debt, the costliness of inflation variability, the level of outstanding government debt…”

On governments potential financial benefit from higher inflation in present times also view post here.

“But the incentive to use surprise inflation to stabilize debt, especially when debt levels are high, can also create significant time consistency issues when policymakers cannot credibly commit. When private agents know that policymakers may be tempted to induce inflation surprises…agents raise their inflation expectations as debt levels rise until that temptation has been offset. This produces a sizeable debt stabilization bias that drives policymakers to reduce debt levels rapidly, at large cost in terms of social welfare, to avoid the high equilibrium rates of inflation associated with the temptation to inflate that debt away.”


Related articles