Working Paper: CEPR ID: DP17690
Authors: Francesco Bianchi; Renato Faccini; Leonardo Melosi
Abstract: We develop a new class of general equilibrium models with partially unfunded debt to propose a fiscal theory of trend inflation. In response to business cycle shocks, the monetary authority controls inflation, and the fiscal authority stabilizes debt. However, the central bank accommodates unfunded fiscal shocks, causing persistent movements in inflation, output, and real interest rates. In an estimated quantitative model, fiscal trend inflation accounts for the bulk of inflation dynamics. As external validation, we show that the model predicts the post-pandemic increase in inflation. Unfunded fiscal shocks sustain the recovery and cause an increase in trend inflation that counteracts deflationary non-policy shocks.
Keywords: unfunded fiscal spending; persistent inflation; large public debt; inflation risk; shock specific rule
JEL Codes: E50; E62; E30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| unfunded fiscal shocks (H69) | persistent inflation (E31) |
| central bank accommodates unfunded fiscal shocks (E62) | sustained movements in inflation (E31) |
| unfunded fiscal shocks (H69) | significant increases in inflation (E31) |
| persistent increase in transfers (H87) | rise in inflation during the mid-1960s (E31) |
| aggressive interest rate hikes by the Federal Reserve (E52) | stabilize unfunded debt (H69) |
| 2021 ARPA fiscal stimulus (E62) | exacerbated post-pandemic inflation (E31) |