Fiscal inflation
If the Fed needs to fight inflation, fiscal constraints on monetary policy will play a large and unexpected role. In 1980, the debt-to GDP ratio was 25 percent. Today it is 100 percent, and rising swiftly. Fiscal constraints on monetary policy are four times larger today—and counting. For a rise in interest rates to lower inflation, fiscal policy must tighten as well. Without that fiscal cooperation, monetary policy cannot lower inflation.
Fiscal Inflation
Author: John H. Cochrane
From: Hoover Institution
The model
In this paper Bianchi and Melosi develop a model to show that the monetary authority’s ability to control inflation is limited when fiscal imbalances are large and fiscal credibility wanes. They argue that it is necessary for monetary tightening to be supported by the expectation of appropriate fiscal adjustments. When this is not the case and fiscal imbalances continue to deteriorate, monetary tightening would actually spur higher inflation and would spark a pernicious fiscal stagflation, with the inflation rate drifting away from the monetary authority’s target and with GDP growth slowing down considerably.
They adjust a New Keynesian model that allows for changes in the Monetary/Fiscal policy mix and introduce agent’s beliefs about whether large fiscal imbalances will be stabilized by taking the necessary fiscal adjustments. Applied to data their model shows that:
- Cost-push shocks only account for short-lasting movements in inflation;
- Before the pandemic, a moderate level of fiscal inflation has counteracted exogenous deflationary pressure and it has helped the Fed to avoid deflation;
- During COVID, the large fiscal stimulus altered people’s beliefs about the sustainability of fiscal imbalances. The result was a big jump in fiscal inflation, accounting for approximately half (3.5%) of the recent increase in inflation.
Inflation as a Fiscal Limit
Authors: Francesco Bianchi, Leonardo Melosi
From: Johns Hopkins University, Federal Reserve Bank of Chicago
The model with heterogeneous agents
In this paper, Narayana Kocherlakota develops a tractable heterogeneous agent New Keynesian (HANK) model that is parameterized so as to admit a bubble in public debt. He shows that when the public debt bubble is large it is impossible to stabilize either inflation or output by varying monetary policy while keeping fiscal policy unchanged. The intuition behind is that in the presence of a bubble, an increase in fiscal spending can be financed solely through the issue of new debt, and does not imply a need for additional future taxes. Since the new public debt generates more asset income for its holders, current fiscal stimulus has an unambiguously positive effect on both current and future demand. When monetary policy fights inflation through interest rate increases it also increases future asset income. Macroeconomic stabilization then can only be accomplished via an continuing, and hence unsustainable sequence, of interest rate hikes.
The contribution of this paper […] is to incorporate public debt bubbles into HANK models, and to show how that feature makes fiscal policy a superior tool for stabilization policy.
Stabilization with Fiscal Policy
Author: Narayana R. Kocherlakota
From: University of Rochester
