Understanding Inflation Dynamics: The Role of Government Expenditure

Abstract

This paper studies the impact of government expenditure on inflation through the lens of an augmented Phillips curve implied from a structural New Keynesian model. Our estimation results, based on external instruments, show that the augmented Phillips curve has a flatter slope than the canonical specification, and government expenditure has a negative coefficient. Changes in government expenditure account for a substantial portion of inflation variations and provide new insights into the "missing disinflation" puzzle. We also find that inflation and inflation expectations respond negatively to fiscal spending shocks, reaffirming the supply-side channel through which inflation responds to fiscal expansions.

Keywords: Inflation, government expenditure, the Phillips curve

JEL Classification: E30, E62