Money growth and inflation: does fiscal policy matter?

The determinants of inflation have long interested both economists and central bankers. This interest has taken on renewed importance in light of a growing consensus that central banks should - first and foremost - pursue price stability. The roots of this argument date back to Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon." Yet recently this view has come under attack. As figure 1 illustrates, there has been virtually no correlation between money growth and inflation since at least the early 1980s.

Is inflation "always and everywhere a monetary phenomenon," as postulated by Friedman? Many doubt this premise, arguing instead that inflation is not the sole province of the central bank, but is also controlled by the fiscal authority. This argument has become known as the fiscal theory of the price level (FT). If fiscal policy drives the inflation rate, inflation targeting becomes problematic.

This Economic Commentary examines two versions of the FT - weak-form FT and strong-form FT. Weak-form FT posits that inflation is indeed a monetary phenomenon, but that money growth is dictated by the fiscal authority. Strong-form FT, on the other hand, argues that even if money growth is unchanged, fiscal policy independently affects the price level and inflation rate. Both versions imply that the central bank may be unable to commit to an inflation target, either because the central bank does not control the money supply (weak form), or because inflation is not necessarily a monetary phenomenon (strong form).

* Weak-Form Fiscal Theory: Fiscal Dominance

On a basic level, the FT argues that the price level is determined by the budgetary policies of the fiscal authority. The interrelationship of fiscal and monetary policy is, in one sense, obvious. Governments have two possible revenue sources at their disposal: taxes and fees of all forms, and seignorage. Seignorage is defined as the revenues obtained from money creation.

The central bank creates money by exchanging dollar bills for government bonds. Money creation increases revenues by decreasing the liabilities of the fiscal authority, and also decreases the liabilities of the Treasury by increasing prices, thus lowering the real value of government debt. Both enable the fiscal authority to tax less or to increase government spending. …

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