Stepping on a rake: The role of fiscal policy in the inflation of the 1970s

ABSTRACT. The inflation of the 1970’s in the US is often discussed as if the only type of policy action that could have prevented the inflation were monetary policy actions and the only type of policy errors that might have induced the inflation were mon-etary policy errors. Yet fiscal policy underwent dramatic shifts in the 70’s and eco-nomic theory makes clear that in an environment of uncertainty about future fiscal policy, monetary policy instruments may lose potency or have perverse effects. This paper documents the vagaries of fiscal policy in this period and argues that people at the time must have been uncertain about fiscal policy’s future course. It also lays out a theoretical framework for understanding the effects of fiscal uncertainties on monetary policy and shows that fiscal variables have predictive value in dynamic models, even if traditional monetary policy indicators are included in the system. I. THE THEORY OF FISCAL AND MONETARY POLICY INTERACTION It is a standard result in equilibrium models that recognize the government bud-get constraint as part of the model (sometimes called “fiscal theory of the price level” or “FTPL ” models) that when rational, forward-looking agents believe that newly is-sued nominal government debt is only partially backed by future taxes, debt issu