Fiscal Deficits and Inflation Risks: the Role of Fiscal and Monetary Regimes

Using data from a panel of advanced economies over four decades, we show that the inflationary effect of fiscal deficits crucially depends on the prevailing fiscal-monetary policy regime. Under a fiscally-led regime, defined as a regime in which the government does not adjust the primary balance to stabilise debt and the central bank is less independent or puts less emphasis on price stability, the average effect on inflation of higher deficits is found to be up to five times larger than under a monetary-led regime. Under a fiscally-led regime, higher deficits also increase the dispersion of possible future inflationary outcomes, especially the probability of high inflation. Based on forecasts from our model, the high inflation experienced by many countries during the recovery from the Covid-19 pandemic appears more consistent with a fiscally-led regime than a monetary-led regime.

Recommended citation: Banerjee, Ryan, Valerie Boctor, Aaron N. Mehrotra, and Fabrizio Zampolli. Fiscal deficits and inflation risks: the role of fiscal and monetary regimes. Bank for International Settlements, Monetary and Economic Department, 2022.
Download Paper