Deficits and Inflation: HANK meets FTPL

In the Fiscal Theory of the Price Level (FTPL), households are Ricardian, so fiscal deficits drive output and inflation only under hard-to-test assumptions about which policy authority is “active” or “dominant.” In the Heterogeneous Agent New Keynesian (HANK) paradigm, households are instead non-Ricardian, so deficits drive aggregate demand, and thereby also inflation, through classical wealth or liquidity effects. Because of this difference, HANK is free of FTPL’s fragilities and controversies. Despite this difference, HANK actually reproduces FTPL’s core empirical predictions regarding the relation between deficits and inflation. This is true even for the most extreme FTPL scenario, where unfunded deficits are financed entirely by inflation-induced debt erosion. In practice, however, deficit-financed fiscal stimuli can help expand output and thus tax revenue, substituting for debt erosion and moderating the associated inflationary pressures.