IEAS Working Paper No. 24-A001, November 2024

Abstract:
The literature on inflation focuses mainly on monetary and structural factors, a notable exception being the Fiscal Theory of the Price Level. Using a model with a conventional regime M and policy target shocks, we demonstrate that fiscal policy played a nontrivial role in inflation in pre-pandemic U.S. history. Policy target shocks allow for deviations from regime M while keeping long-term expectations anchored in this regime. Historical decomposition reveals that inflation target shocks were substantial during the inflation surges of the 1970s. Tax cuts during the Reagan administration eased inflation, while rising debt targets after the mid-1980s exerted inflationary pressure.