Fiscal Policy and Inflation

Abstract

Most inflation research before the pandemic emphasizes monetary and structural factors, with the Fiscal Theory of the Price Level (regime F) as an exception. Using an estimated New Keynesian model under the conventional regime M with stochastic policy targets, we show that fiscal policy played a nontrivial role in pre-pandemic U.S. inflation. These shocks allow temporary deviations from regime M while keeping long-term inflation expectations anchored. Historical decomposition underscores the importance of inflation target shocks during the 1970s. Tax cuts were not uniformly inflationary; Reagan-era cuts aided disinflation. Transfer shocks persistently raised prices, but less than in a regime-F-dominated environment.

Keywords: inflation, fiscal policy, fiscal and monetary policy interaction, policy target shocks, New Keynesian models

JEL Classification: E52, E62, E63, H30