Fiscal Policy and Inflation: The Forgotten Role of Government Budgets

Fiscal policy is rarely framed as a cause of inflation. The dominant story since the 1970s placed monetary policy at the centre and treated the budget as either passive or politically downstream. The Fiscal Theory of the Price Level overturns that ordering: when markets doubt the real value of repayment, the price level adjusts, not the nominal debt.

Sims, Cochrane, Bianchi and Melosi have spent two decades formalising how active fiscal policy can drive inflation independently of monetary policy. The 2020-2024 episode pushed this framework from theoretical curiosity to practical relevance.

This article isolates fiscal policy as a cause of inflation through three frameworks: the Fiscal Theory of the Price Level (Sims-Cochrane), the Bianchi-Melosi 2019 fiscal-monetary mix, and Leeper’s 1991 active/passive policy regime taxonomy. The mechanical channel by which the State benefits from inflation surprise — Sargent-Wallace 1981 unpleasant arithmetic — is treated separately in the satellite on the State and inflation. Here, the question is the opposite: how does fiscal policy itself produce inflation?

The Fiscal Theory of the Price Level

Cochrane (2023) treats FTPL as a complement to standard monetary analysis rather than a replacement. The framework predicts that pure monetary tightening — raising rates without a fiscal anchor — can fail to control inflation if markets read the higher rates as raising future debt-service costs without a credible offsetting fiscal adjustment. The 2022-2024 cycle stress-tested this prediction. The Federal Reserve raised the federal funds rate by 525 basis points; CPI inflation fell from 9.1% in mid-2022 to 3.0% by mid-2024. The disinflation occurred, but the FTPL frame argues the rate hikes alone would have been insufficient absent the implicit fiscal adjustment that emerged from inflation-driven nominal-tax growth.

The mechanical chain in the FTPL framework runs as follows. Suppose the government runs persistent primary deficits and markets revise downward their estimate of future surpluses needed to honour the debt at face value. The real value of outstanding debt has to fall to match the lower expected future surpluses. There are three adjustment paths: an explicit default on nominal claims (rare among advanced-economy reserve currency issuers), a higher real interest rate that makes future surpluses more valuable in present terms (constrained by central bank policy and demand-side feedback), or a higher price level that erodes the real value of nominal liabilities. Cochrane argues the third path is the one most economies actually take. The implication is that fiscal policy is not always upstream of monetary policy in the inflation-determination chain — sometimes it is the inflation itself.

The fiscal-monetary mix

Bianchi and Melosi (2019, American Economic Review, “The Dire Effects of the Lack of Monetary and Fiscal Coordination”) formalised the interaction between fiscal credibility and monetary policy effectiveness. Their structural VAR estimates of 1962-2017 U.S. data identified two regimes: a fiscal-active/monetary-passive regime in which fiscal policy drives the price level (broadly the 1970s and post-2008), and a fiscal-passive/monetary-active regime in which monetary policy controls inflation (broadly the Volcker-Greenspan-Bernanke era pre-2008). Switches between regimes are estimated to drive inflation expectations through the credibility channel. The complete picture is set out in our reference work on inflation regime drivers. The 2020-2024 inflation episode is read in this framework as a regime drift toward fiscal-active territory, which limits the disinflationary power of monetary tightening. The complete framework is detailed in our reading of inflation transitions.

Leeper (1991, Journal of Monetary Economics, “Equilibria under ‘active’ and ‘passive’ monetary and fiscal policies”) supplied the original taxonomy. He defined “active” monetary policy as one that responds aggressively enough to inflation to satisfy the Taylor principle, and “active” fiscal policy as one that does not adjust primary surpluses to stabilise the debt-to-GDP ratio. Of the four possible combinations, only two produce determinate equilibria: active monetary + passive fiscal (the standard New Keynesian case) and passive monetary + active fiscal (the FTPL case). The other two combinations either generate explosive debt or indeterminate inflation. Inflation and the State covers the mechanical channels through which the budget benefits from inflation regardless of which regime applies.

Blanchard 2019 and the low-rate regime

Blanchard’s 2019 AEA Presidential Address (“Public Debt and Low Interest Rates”) introduced a different angle: when the real interest rate on public debt persistently runs below the real growth rate (r

The implication for inflation is indirect but substantial. Under the r Inflation and bonds traces the bond-market signal of regime shift, and negative real rates and their consequences documents the regime that made the r

Empirical episodes

Three episodes provide partial empirical validation. The 1970s U.S. inflation overshoot featured a sustained fiscal expansion under the Vietnam-Great Society overlap, and the Volcker disinflation succeeded in part because it coincided with the early Reagan-era promise of fiscal discipline (later only partially honoured). The Italian 1970s-1980s inflation episode featured chronic fiscal-active behaviour in a small open economy with a non-reserve currency, ultimately resolved by the EMS commitment and eurozone accession. The post-2020 U.S. episode combined fiscal expansion with a pandemic supply shock; FTPL-aligned analysts argued the inflation overshoot would not have occurred at the same magnitude under fiscal-passive policy, while Keynesian-aligned analysts emphasised the supply-side explanation. Nominal vs real economic data traces the household-level transmission of these episodes.

Sargent (1982, “The Ends of Four Big Inflations”) documented the converse: how disinflations succeed when fiscal regimes shift credibly. The four hyperinflations he studied (Austria, Germany, Hungary, Poland 1922-1924) ended abruptly when fiscal-active regimes switched to fiscal-passive, producing rapid stabilisation without the prolonged recession that monetary tightening alone typically requires. The lesson is symmetric to FTPL’s prediction: the price level is anchored by fiscal credibility as much as by monetary credibility. The Mexican stabilisation of the late 1980s, the Brazilian Real Plan of 1994, and the Turkish disinflation episodes all involved fiscal-monetary co-ordination as the core mechanism, not isolated monetary tightening.

The Japanese case is the principal counter-example to fiscal-driven inflation. Japan has run sustained deficits since the early 1990s and accumulated a gross debt-to-GDP ratio above 250% by 2024 — the highest among major advanced economies — while inflation remained below 1% on average over 1995-2020. The simplest reading is that monetary regime credibility, demographic forces and chronic demand weakness offset what would otherwise have been fiscal-driven inflation. The Japanese experience does not falsify FTPL — Cochrane 2023 explicitly addresses the case — but it constrains the framework’s predictive scope: fiscal-active behaviour does not automatically translate to inflation absent specific transmission conditions. Real interest rates history provides the underlying real-rate trajectory that frames each of these episodes.

The MMT comparison

The MMT framework and the FTPL framework reach the same accounting identity from different starting points. MMT begins from monetary sovereignty and concludes that fiscal capacity is constrained only by inflation; FTPL begins from sovereign solvency and concludes that the price level is determined by fiscal expectations. Both treat fiscal policy as the dominant variable in inflation determination under specific conditions. They differ on the policy implications: MMT advocates fiscal expansion until inflation binds, while FTPL warns that fiscal expansion can shift inflation expectations even before output gaps close. The MMT analysis develops the comparison in detail.

Where this leaves the analytical comparison

Treating monetary policy as the sole inflation-control instrument is a regime-specific assumption, valid in the Volcker-Greenspan-Bernanke window but not universally. Active fiscal policy can drive inflation through the FTPL channel; the fiscal-monetary mix matters for the effectiveness of monetary tightening; the Blanchard r

For the broader inflation framework, see the complete inflation guide and the inflation regimes pillar that situates the fiscal-monetary mix within the wider regime taxonomy. Breakeven inflation rates provides the market-implied signal that any fiscal regime must contend with.

Last updated — 7 May 2026