Do Budget Deficits Cause Inflation ?

In 2004, the federal budget deficit stood at $412 billion and reached 4.5 percent of gross domestic product (GDP). Though not at a record level, the deficit as a fraction of GDP is now the largest since the early 1980s. Moreover, the recent swing from surplus to deficit is the largest since the end of World War II (Figure 1). The flip side of deficit spending is that the amount of government debt outstanding rises: The government must borrow to finance the excess of its spending over its receipts. For the U.S. economy, the amount of federal debt held by the public as a fraction of GDP has been rising since the early 1970s. It now stands at a little over 37 percent of GDP (Figure 2). For a long time, economists and policymakers have worried about the relationship between government budget deficits and inflation. These worries stem from the possibility that the government will finance its deficits by borrowing or by printing money. Should deficit spending and a large public debt be worrisome for monetary policymakers who are concerned about the economy’s level of inflation? Do government budget deficits lead to higher inflation? When looking at data across countries, the answer is: it depends. Some countries with high inflation also have large government budget deficits. This suggests a link between budget deficits and inflation. Yet for developed countries, such as the U.S., which tend to have relatively low inflation, there is little evidence of a tie between deficit spending and inflation. Why is it that budget deficits are associated with high inflation in some countries but not in others? The key to understanding the relationship between government budget deficits and inflation is the recognition that government deficit spending is linked to the quantity of money circulating in the economy through the government budget constraint, which is the relationship between resources and spending. At its most basic level, the budget constraint shows that money spent has to come from somewhere: in the case of local and national governments, from taxes or borrowing. But national governments can also use monetary policy to help finance the government’s deficit. The extent to which monetary policy is used to help balance the government's budget is the key to determining the effect of budget deficits on inflation. In this article, we will examine theory and evidence on the link between fiscal and monetary policy and, thus, between deficits and inflation.