Fiscal Deficits Drive Higher Inflation

Larry Swedroe

The growth of the federal deficit in the post-COVID era, coupled with the political unwillingness to increase taxes, foretells higher-than-historical inflation rates, according to new research.

The fiscal theory of the price level has been around since the early 1990s. The research on the theory was summarized and extended in John Cochrane’s 2023 book. As Cochrane explained, prices adjust so that the real value of government debt equals the present value of taxes less spending. Inflation breaks out when people don’t expect the government to fully repay its debts.

With the theory in mind, Robert Barro and Francesco Bianchi, authors of the November 2023 study, “Fiscal Influences on Inflation in OECD Countries, 2020-2022,” examined the role of fiscal expansion as a determinant of inflation rates in 37 OECD countries over the period 2020-2022. They used the key ingredients of the fiscal theory of the price level to work out a relation between inflation rates and government spending, and applied this specification to measures of headline and core CPI inflation rates along with information on changes in general government primary expenditure, public-debt levels and debt duration.