Money Growth and Inflation: Does Fiscal Policy Matter?

Article excerpt

The determinants of inflation have long interested both economists and central bankers. This interest has taken on renewed importance in light of a growing consensus that central banks should -first and foremost-pursue price stability. The roots of this argument date back to Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon." Yet recently this view has come under attack. As figure 1 illustrates, there has been virtually no correlation between money growth and inflation since at least the early 1980s.

Is inflation "always and everywhere a monetary phenomenon," as postulated by Friedman? Many doubt this premise, arguing instead that inflation is not the sole province of the central bank, but is also controlled by the fiscal authority. This argument has become known as the fiscal theory of`the price level (FT ). If fiscal policy drives the inflation rate, inflation targeting becomes problematic.

This Economic Commentary examines two versions of the FT--weak-form FT and strong-jorm FT. Weak-form FIT posits that inflation is indeed a monetary phenomenon, but that money growth is dictated by the fiscal authority. Strongform FT, on the other hand, argues that even if money growth is unchanged, fiscal policy independently affects the price level and inflation rate. Both versions imply that the central bank may be unable to commit to an inflation target, either because the central bank does not control the money supply (weak form), or because inflation is not necessarily a monetary phenomenon (strong form).

Weak-Form Fiscal Theory: Fiscal Dominance

On a basic level, the FT argues that the price level is determined by the budgetary policies of the fiscal authority. The interrelationship of fiscal and monetary policy is, in one sense, obvious. Governments have two possible revenue sources at their disposal: taxes and fees of all forms, and seignorage. Seignorage is defined as the revenues obtained from money creation.

The central bank creates money by exchanging dollar bills for government bonds. Money creation increases revenues by decreasing the liabilities of the fiscal authority, and also decreases the liabilities of the Treasury by increasing prices, thus lowering the real value of government debt. Both enable the fiscal authority to tax less or to increase government spending.

Long-run monetary and fiscal policy are jointly determined by the fiscal budget constraint. The FT involves an assumption about which policymaker moves first, the central bank or the fiscal authority. In other words, who is responsible for seeing that the government's long-term budget constraint is satisfied'? This relationship between the monetary and fiscal authority (that is, Congress) has been described as a "game of chicken."

Traditional versions of the FT (which we call weak-form FT) assume fiscal dominance. That is, the fiscal authority moves first by committing to a path for primary budget surpluses, forcing the monetary authority to generate the seignorage necessary to maintain solvency. Using the game-of-chicken analogy, the FT assumes that the monetary authority loses and is forced to "blink."

The central bank thus reacts to changes in fiscal policy by changing either current money or future money growth (inflation). Holding future inflation constant, an increase in current and future budget deficits necessitates increasing current (nominal) money. If current money, however, is held constant, then the monetary authority must increase future inflation. Thus, an increase in future deficits must result in either a one-time increase in money (a one-time jump in the price level) or an increase in future money growth (future inflation). Monetary revenues to finance deficits can be raised by increasing the tax on money today or tomorrow.

The implication of fiscal dominance, or the weak-form FT, is not that monetary movements do not determine the price level. …