On the Low-Frequency Relationship Between Public Deficits and Inflation

Abstract

Summary We estimate the low‐frequency relationship between fiscal deficits and inflation and pay special attention to its potential time variation by estimating a time‐varying vector autoregression model for US data from 1900 to 2011. We find the strongest relationship neither in times of crisis nor in times of high public deficits, but from the mid 1960s up to 1980. Employing a structural decomposition of the low‐frequency relationship and further narrative evidence, we interpret our results such that the low‐frequency relationship between fiscal deficits and inflation is strongly related to the conduct of monetary policy and its interaction with fiscal policy after World War II.Copyright © 2015 John Wiley & Sons, Ltd.

Identifying Fiscal Inflation

“…We thus sidestep the challenges that come with formalizing …scal policy. Third, DSGE estimation, by formally taking account of agents'responses to information about the future, is a commonly used solution to Finally, our results complement recent empirical work that argues that the 1970's in ‡ation is related to …scal policy, such as Sims (2011), Bianchi and Ilut (2012), Bhattarai, Lee and Park (2012) and Kliem, Kriwoluzky and Sarferaz (2013). The same theoretical models that rationalize the …scal in ‡ation of the 70's rationalize our …ndings.…”

Public debt, money and consumer prices: a vector error correction model for Germany

“…Independent central banks and the high reputation from the capital market players contribute to a more stable financial position in the developing countries, so that public deficits predominantly do not lead to high inflation rates. Kliem et al [2013], show that the positive long-run relationship between public deficits and inflation in the USA suddenly diminished after 1979 and has remained insignificant ever since. The strongest correlation was found for the period from the mid 1960s to 1979.…”

U.S. Monetary-Fiscal Regime Changes in the Presence of Endogenous Feedback in Policy Rules

“…While economic theory emphasizes how policies in a particular monetary and fiscal regime must interact to determine the price level uniquely, previous empirical studies in monetary and fiscal policy interactions tend to focus on dynamic patterns of correlation among policy variables (King and Plosser (1985), Melitz (1997Melitz ( , 2000, von Jagen et al (2001), Muscatelli et al (2002) and Kliem et al (2016)). …”

“…Since the latent policy regime factors are not observable, economic agents also estimate the latent policy regime factors to make an inference about current and future policy regimes as econo-21 Kliem et al (2016) argue that the low-frequency relationship between primary deficits over debt and inflation has become insignificant after 1980 as the Fed kept active regime independently after 1980. However, we observe a strong interaction between policy regime factors with a large magnitude of responses after the 1990s.…”

“…Melitz (1997Melitz ( , 2000 investigates the interaction between monetary and fiscal policies over the business cycle using a data set for 19 OECD countries and shows that the two policies tend to move in opposite directions. Kliem et al (2016) estimate the low-frequency relationship between primary deficits over debt and inflation in a time-varying VAR model for U.S. data. They find that the relationship between inflation and primary deficits over debt is mostly positive before 1980 and insignificantly different from zero after 1980.…”