Do Enlarged Fiscal Deficits Cause Inflation: The Historical Record
In this paper we survey the historical record for over two centuries on the connection between expansionary fiscal policy and inflation. As a backdrop, we briefly lay out several theoretical approaches to the effects of fiscal deficits on inflation: the earlier Keynesian and monetarist approaches; and modern approaches incorporating expectations and forward looking behavior: unpleasant monetarist arithmetic and the fiscal theory of the price level.
We find that the relationship between fiscal deficits and inflation generally holds in wartime when fiscally stressed governments resorted to the inflation tax. There were two peacetime episodes in the early twentieth century when bond financed fiscal deficits that were unbacked by future taxes seem to have greatly contributed to inflation: France in the 1920s and the recovery from the Great Recession in the 1930s in the U.S. In the post-World War II era a detailed examination of the Great Inflation in the 1960s and 1970s in the U.S. and the U.K. suggests that fiscal influences on monetary policy was a key factor. Finally we contrast the experience of the Great Financial Crisis of 2007-2008, when both expansionary fiscal and monetary policy did not lead to rising inflation, with the recent pandemic, which may involve the risks of fiscal dominance and future inflation.
Paper prepared for the IIMR Annual Monetary Conference “The Return of Inflation? Lessons from History and Analysis of Covid -19 Crisis Policy Response” organized by University of Buckingham, England, October 28 2020. For helpful comments on an earlier draft we thank: Michael Boskin, Andy Filardo, Harold James, Owen Humpage, Eric Leeper and Hugh Rockoff. For valuable research assistance we thank Roiana Reid and Humberto Martinez Beltran. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.