Fiscal Dimensions of Inflationist Monetary Policy

Introduction

Policymakers and the public have held fast to price stability ever since the Federal Reserve under the leadership of Paul Volcker brought the “Great Inflation” to an end in the mid-1980s. Broadbased support for low inflation was born of the memory of what high and variable inflation had wrought and what price stability has yielded. For instance, unemployment in the United States averaged around 4 ½% from 1950 to 1970, then rose and fluctuated with inflation and averaged nearly 7% from 1970 until 1985. After inflation was stabilized, average unemployment fell back to 5 ½% prior to the recent credit turmoil and its aftermath.

The broad-based support for price stability is at risk today in the United States and in Europe. Prominent voices in academia, the media, the International Monetary Fund, and inside the Federal Reserve have proposed that the commitment to price stability should be relaxed in one way or another to concentrate on achieving more pressing objectives. The inflationist policy proposals are varied with respect to their objectives and operating guides. For instance, the objectives range from reducing unemployment, to depreciating the real public debt, to facilitating international adjustment within the Euro area.

Below, I compare and contrast various inflationist proposals and consider their overall advisability in light of lessons from the Great Inflation. Before doing so, however, I consider the costs involved in employing available stimulative policies more intensively as envisioned in these proposals. I presume that interest rate policy is immobilized at the zero bound, as is the case in Japan and nearly the case in the US and the Euro area. That leaves three options: monetary policy, portfolio maturity extension, and credit policy. Importantly, all these remaining alternatives exert stimulus via fiscal policy. I describe the costs, risks and effectiveness of employing these measures more intensively in terms of their implicit fiscal policy dimensions and explicit budgetary costs to taxpayers. I group various “inflationist” proposals together for consideration according to their aggressiveness---whether they are willing to risk higher inflation, to tolerate higher inflation, or target higher inflation temporarily or persistently to achieve other objectives.

I conclude by recalling why higher inflation worsened unemployment during the Great Inflation. The lesson is that any short run employment benefits that might be achieved by tolerating higher inflation today, and these are questionable, would likely produce protracted adverse effects on unemployment in the future as inflation scares repeatedly force the Fed into contractionary interest rate actions.

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