Fiscal Stimulus and Inflation

Joe Biden’s Fiscal Stimulus heralds the largest US government intervention in the economy in decades. As can be seen in the graphic above, the plan is the largest in the world. Though all governments have had to carry out unplanned spending, the US plan is ambitious and unique. Unlike the UK, low and middle income households have received 2 direct cash handouts. Not only is the aim of this massive stimulus package to achieve rapid recovery from the corona virus pandemic; with massive infrastructure and education spend, they hope to rebuild the economy, achieve socio and environmental goals and rapidly improve America’s infrastructure (roads, utilities) which is widely seen as crumbling.

When governments spend (or ‘print money’ as with Quantitative Easing), Economists ask 2 key questions: how will the spending be paid for, and will it be inflationary?

Here we will focus on the question of inflation. Inflation matters because rising prices lower our real incomes and thus directly impact our standard of living. If inflation is rising it also makes sense to borrow rather than save — and this can cause further inflation. When prices really get out of control, firms are less likely to invest as their ability to predict the value of their future earnings diminishes. All these impacts make inflation undesirable. For sustainable economic growth, we need low, predictable inflation (hence the Bank of England’s target of 2% inflation).

So, in light of the pandemic, have governments around the world simply abandoned their inflation targets? Do they no longer care? Or are Team Biden (and Rishi Sunak too, in the UK), estimating that the extra money in the economy’s pocket is unlikely to cause inflation?

In the simplest terms, inflation is caused when “too much money is chasing too few goods” (Milton Friedman, Nobel Prize winning Economist).

If the government pumps extra spending power into the hands of government departments (education, transport, health), and consumers and firms, we expect that consumers, firms and government departments will spend that money. They will wish to spend it on consumer goods, investment, healthcare, vaccines and so much more. If the goods and services are not forthcoming — if there is a lack of supply — then the higher demand will indeed cause prices to be bid upwards. This will then trigger inflation.

Economists model this with an AD AS diagram.

Aggregate Demand represents spending in the economy. Spending by consumers, firms, governments and foreigners who buy our exports (less our spending on imports).

Aggregate Supply represents the total output or production of all goods and services.

In the diagram above, we start at AD1. More spending causes aggregate demand to rise. It eventually reaches AD2. We can see that the price level does not change. And this is because, in the range shown, the supply of goods and services (AS) can meet the demand for goods and services. Given that we have been in a pandemic, that unemployment has been rising, that shops and factories have been lying idle, it is probably the case that firms can call forth resources and increase production to meet this new demand.

But once these unemployed resources have been used — employed — we hit a bottleneck. This is where the AS curve starts to increase in slope and eventually, when there are no more resources to call upon, it becomes vertical. If demand continues to rise past the point at which firms can respond, then we can see that at AD3, the price level increases to P1. This is inflation.

Is the Biden plan going to be inflationary? We cannot be certain. As can be seen in the diagrams above, the way to avoid inflation is to increase the economy’s capacity to supply the goods and services that are in demand. Diagrammatically, the Aggregate Supply Curve needs to shift to the right.

This in turn is achieved by having more resources available (more land, more labour) and better still, improving the productivity with which existing resources can produce goods and services. This comes about through investment. Investment in technology, education, infrastructure. As the graphic below shows, the Biden plan involves significant infrastructure spend. If this works, our diagram shows that the move of AS to AS2 allows for economic growth to Y3 and a little bit of inflation only to P2.

Will the infrastructure spending be enough? Will it work? How long will it take before that spending delivers increased capacity to AS2? It does take time to make productivity gains. Building more roads or spending more on education can take decades to have any significant effect on productivity. As a result, we may well see some short term inflationary impact.

But inflation also depends on the extent to which firms and workers are willing to absorb any increased costs. As we near full capacity and the prices for some resources begin to rise, firms don’t have to raise the final prices of their products. They could absorb the higher costs. If prices rise, workers don’t have to ask for higher wages (and firms don’t have to award higher wages). The greater the degree of competition in a market, the less likely a firm is to raise its prices. The greater the likelihood of a worker being replaced by other workers (eg through immigration or outsourcing), or be replaced by technology, the less successful that worker is likely to be in achieving a wage increase. This then helps the firm to keep its prices down. So a flexible and competitive labour and product market makes inflation less likely.

To conclude then, there is likely to be some inflationary pressure from these stimulus packages. It is very much dependent on the speed at which the spending enters the economy and the speed and ease with which supply can respond. The US government will need to ensure that the investment it is making into so many parts of the economy actually delivers — that it actually raises productivity. And if price pressures begin to manifest, the US Federal Reserve will raise interest rates, which in turn will need to be significant to slow the rise of aggregate demand.

Further reading:

Passionate about using economics to understand the everyday https://www.facebook.com/Everyday-Economics-104573444978165