The Fiscal Transmission Mechanism of Inflation
American Business Review, forthcoming
23 Pages Posted: 9 Feb 2023 Last revised: 3 Mar 2023
Date Written: February 7, 2023
The link between money creation and inflation has been theoretically demonstrated, but different inflation responses to Federal Reserve activity after the Great Recession and COVID recession showed the incomplete nature of the theory. We model a ``fiscal transmission mechanism'' whereby Federal Reserve purchases of Treasury securities lead to inflation as new dollars flow through fiscal deficits into the economy. In our model, other Federal Reserve activity generally lacks inflationary effects. Using a nonstructural vector autoregression approach, we test for the presence of this mechanism and offer near perfect predictions of the 2022 inflation rate using a time series extending back half a century. We explain the fiscal transmission mechanism and the reasons why other Federal Reserve activity lacks the same effects, and we propose an emphasis on controlling the money supply by limiting Federal Reserve purchases of Treasury securities as a better way to control inflation than setting an interest rate target.
Keywords: inflation, transmission mechanism, monetary policy, fiscal policy, budget deficits
JEL Classification: E63, E31, E58, H63
Suggested Citation: Suggested Citation