Ways Fiscal Policy Can Cause Inflation

1. portfolio effects. I discussed this mechanism in my last post.
   
   
2. gradual loss of confidence in financial assets. (This could be considered an example of, or a justification for, portfolio effects, but I’ll treat it as a separate mechanism.) Ultimately, a looser fiscal policy may be unsustainable. If it is truly unsustainable, then it will eventually have to be reversed, and the reversal could take the form of either a fiscal contraction or a monetary expansion (the “inflation tax”). It is hard to know in advance whether a fiscal policy is truly unsustainable, and it is also hard to anticipate how it might eventually be corrected. As a loose fiscal policy continues (which is to say, as more time passes over which it is not corrected by fiscal means), the odds of its being corrected by monetary means will tend to rise. The greater the chance of a monetary expansion, the less valuable financial assets (money and bonds) are at any given interest rate. Thus there will be a gradual shift in portfolio preferences from financial assets to real assets. If the money supply is constant (or, more generally, if it grows with productivity) and the economy is at full employment, then prices will rise gradually over a long period of time: inflation.
   
   
3. gradual loss of confidence in the pricing structure. If price setting depends on expected price levels (as in New Classical and some New Keynesian models), the gradually increasing expectation of an eventual monetary stimulus will lead to a gradual shift in the Phillips curve, thus causing prices to rise gradually for any given level of nominal aggregate demand.
   
   
4. reduced productivity growth due to crowding out. At full employment, in a closed economy, a fiscal stimulus will crowd out private investment, thus causing the capital stock to grow more slowly. As a result, productivity will grow more slowly, and real income will grow more slowly. For any given path of money supply and money demand, this means the price level will rise more quickly.
   
   
5. a naïve Taylor rule. Thus far, I’ve assumed that the money supply is exogenous and inelastic. That’s clearly unrealistic. To get slightly more realistic, suppose that monetary policy follows a Taylor rule with a fixed estimate of the “netural interest rate.” A fiscal stimulus will raise the interest rate consistent with stable prices. If monetary policy continues to follow its Taylor rule, the equilibrium inflation rate will rise.
   
   
6. inertial inflation. In practice, when we observe increases in the price level, it’s very hard (even for economists, and all the more for naïve price-setting agents) to tell whether they are one-time increases or “true” inflation. When fiscal policy produces rising prices, these will therefore tend to increase expected inflation, and the increase in expected inflation will become a self-fulfilling prophecy.
   
   People are going to complain about #6, because the self-fulfilling prophecy ultimately requires monetary accommodation. Otherwise the rising rate of price growth will eventually result in a reduced level of output, and the expectations will eventually be corrected.
   
   But here is the thing: what we really mean by higher inflation – in this era of enlightened and hawkish monetary policy – is not a permanent increase in the rate of price growth; what we mean is an increase in the rate of price growth that will be of concern to a central bank that wants to prevent a permanent increase in the rate of price growth. When people complain about fiscal policy being inflationary, they don’t mean that it actually will result in persistent inflation; they mean that it will raise a red flag at the Fed. In a perfect world where price-setting agents were perfectly rational and could perfectly discriminate temporary from permanent changes in nominal demand (and where the simple version of the IS-LM model applied), a loosening of fiscal policy would not raise such a red flag. In the real world, it does.