posted on 22 May 2016
from the St Louis Fed
-- this post authored by William Dupor, Assistant Vice President
Lackluster U.S. gross domestic product (GDP) growth may lead to renewed calls for new government spending to stimulate the economy.  One possible justification is that an increase in government purchases might drive up the cost of production. In turn, this would drive up inflation. So long as the Federal Reserve does not counteract this increase with restrictive monetary policy, the increase in inflation might drive down the real interest rate.  A lower cost of borrowing might drive up households' consumption and businesses' investment in equipment and structures.
This is an interesting theoretical mechanism by which government spending stimulus might increase output indirectly though inflation. Whether this channel works empirically is another question. It also goes to the broader question of how inflation is affected by fiscal policy.
Words from Milton Friedman
In a debate from nearly 50 years ago, economist Milton Friedman characterized the then-current state of economists' understanding about fiscal policies' effect on inflation: "Surely, I think the time has come to utter the usual poker challenge to those who maintain that fiscal effects are important for inflation and the price level. It seems to me that it is time they put up and give us some evidence to support the repeated assertions to that effect." 
Until recently, Friedman's quote has remained pretty accurate. Why have economists had little to say empirically about the effect of government spending on inflation? I studied this question in a recently published paper co-authored with Rong Li of Renmin University of China.
There are two high hurdles to answering this question that only a few papers have been able to overcome:
We overcame the first hurdle by looking at the U.S. between 1959 and 1979, when the Fed followed a policy in which it accommodated increases in inflation. We overcame the second challenge by using a host of procedures economists have previously used to isolate exogenous changes in government spending.
Little to No Effect on Inflation
Across the board, we found almost no effect of government spending on inflation. For example, in our benchmark specification, we found that a 10 percent increase in government spending led to an 8 basis point decline in inflation. Moreover, the effect is not statistically different from zero.
Does our finding, by itself, imply that countercyclical government spending is ineffective at boosting output? Not necessarily. Our paper simply demonstrates that the inflation channel of government spending is not an empirically important way that this spending might affect the economy.
Notes and References
1 Real GDP growth for the first quarter of 2016 was 0.5 percent at a seasonally adjusted annual rate.
2 One reason that a central bank might not counteract the potentially inflationary effect of government spending is that the nominal interest rate might already be stuck at the zero lower bound. Even if the central bank were not stuck at the zero lower bound, it might choose to not pursue a contractionary monetary policy because it recognized that the economy was in a recession.
3 Friedman, Milton; and Heller, Walter. "Monetary vs. Fiscal Policy: A Dialogue," New York: Norton, 1969.
4 Dupor, William; and Li, Rong. "The Expected Inflation Channel of Government Spending in the Postwar U.S.," European Economic Review, 2015, Vol. 74, pp. 36-56.
5 These include, for example, using variables related to new military spending, such as stock returns on defense industry firms.
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