Fiscal deficits and inflation risks: the role of fiscal and monetary policy regimes

Using data from a panel of advanced economies over four decades, we show that the inflationary effect of fiscal deficits crucially depends on the prevailing fiscal-monetary policy regime. Under fiscal dominance, defined as a regime in which the government does not adjust the primary balance to stabi...

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Bibliographic Details
Published inIDEAS Working Paper Series from RePEc
Main Authors Banerjee, Ryan Niladri, Boctor, Valerie, Mehrotra, Aaron, Zampolli, Fabrizio
Format Paper
LanguageEnglish
Published St. Louis Federal Reserve Bank of St. Louis 01.01.2022
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Summary:Using data from a panel of advanced economies over four decades, we show that the inflationary effect of fiscal deficits crucially depends on the prevailing fiscal-monetary policy regime. Under fiscal dominance, defined as a regime in which the government does not adjust the primary balance to stabilise debt and the central bank is less independent or puts less emphasis on price stability, the average effect on inflation of higher deficits is found to be up to five times larger than under monetary dominance. Under fiscal dominance, higher deficits also increase the dispersion of possible future inflationary outcomes, especially the probability of high inflation. Based on forecasts from our model, the high inflation experienced by many countries during the recovery from the Covid-19 pandemic appears more consistent with a regime of fiscal dominance than monetary dominance.