Intro: Loose fiscal policy tends to be a major cause of inflation as it increases government spending without increasing real output or reducing the spending of the private sector. Even if governments issue bonds rather than printing money directly to pay for the deficits, the inflationary impact remains largely the same.
When the government spends more than it takes in in taxes, the additional spending does not create additional goods and services, but competes for the existing amount of goods and services available in the economy, raising prices. Even if the government issues bonds to ‘soak up liquidity’ in an attempt to reduce private sector spending, rather than printing money directly, the inflationary impact is not meaningfully reduced.
Governments can attempt to ‘sterilise’ the increase in money supply resulting from excessive spending relative to revenues by increasing bond issuance. However, while bonds are different in many ways to money, their issuance can have very similar effects on inflation, which helps explain why fiscal deficits tend to be inflationary. When governments run large fiscal deficits and issue debt to fund them, the increase in financial assets (government bonds) held by the public as a result acts as a form of monetary ‘wealth’. This increase in monetary wealth in the hands of businesses and consumers often leads to an increase in the demand for goods relative to money. In other words, as people hold more financial assets, they become more willing to spend the cash that they have.
Large fiscal deficits also crowd out more productive private sector investment and undermine real GDP growth over the medium term. Lower real GDP growth results in a higher rates of inflation all else equal as explained here Fast Growth and Low Unemployment Do Not Cause Inflation. Fiscal deficits also tend to result in high levels of government debt, and therefore a tendency for central banks to keep monetary policy loose so as to not increase the government’s debt servicing costs.
Case Study: Why Fiscal Deficits Have Not Been Inflationary in the US
The fact that the US has continued to experience low inflation despite its large fiscal deficit is not evidence that fiscal deficits are not inflationary, but rather that their inflationary impact has been outweighed, for now, by other disinflationary forces. These have come in three forms:
Firstly, foreign central banks have continued to increase their purchases of US assets, putting upside pressure on the demand for dollar. So while the increase in government bond issuance would ordinarily have led to an increase in inflation, this has been offset by the increase in overseas demand for dollars.
Secondly, the economy has continued to exhibit positive real GDP growth meaning that the increase in the money and bond supply has been partially offset by an increase in the availability of goods and services.
Thirdly, there has been a strong willingness on the part of US citizens to continue hoarding the ongoing increase in money supply and government bonds. The most likely explanation is that much of the additional creation of money and bonds over the past decade has ended up in the hands of the wealthiest people in the country who have a lower propensity to spend the money in percentage terms, effectively allowing it to maintain its value.