Financial Distress and Fiscal Inflation

Abstract

Is inflation 'always and everywhere a monetary phenomenon' or is it fundamentally a fiscal phenomenon? The answer hinges crucially on the underlying monetary-fiscal policy regime. Scant attention has been directed to the role of credit market frictions in discerning the policy regime, despite its growing importance in empirical macroeconomics. We augment a standard monetary model to incorporate fiscal details and credit market imperfections. These ingredients allow for both interpretations of the inflation process in a financially constrained environment. We find that introducing financial frictions to the model and adding financial variables to the dataset generate important identifying restrictions on the observed pattern between inflation and measures of financial and fiscal stress, to the extent that it overturns existing findings about which monetary-fiscal policy regime produced the U.S. data. To confront policy regime uncertainty, we propose the use of dynamic prediction pools and find strong cyclical patterns in the estimated historical regime weights.

Keywords: monetary and fiscal policy, financial frictions, model comparison, dynamic prediction pool

JEL Classification: C52, E44, E63