INFLATION AND GOVERNMENT DEFICITS

Abstract

There is a pronounced positive correlation of inflation andgovernment deficits in the United States since World War II.The purpose of this paper is to test the three leading explanationsof this correlation. These three explanations are: (a) a deficitincreases prices through a wealth effect; (b) a deficit results inthe Federal Reserve purchasing debt, thus increasing the moneysupply and prices; and (c) expected inflation increases the deficit(which is the change in the nominal value of bonds). No supportis found for either of the first two hypotheses. The results indi-cate that expected government deficits have no significance forfuture inflation.Since World War II, the United States has experienced large federal-government deficits and a sustained peacetime inflation. Three differentconnections between the deficits and inflation are prominent in theliterature.The most direct connection between government deficits and inflationis that by increasing the real value of outstanding bonds and perceived netwealth, a deficit can raise total spending and the price level. This connec-tion is also the most long-standing and is suggested by Metzler (1951) andPatinkin (1965) for example.Monetarists generally and Buchanan and Wagner (1977) in particularhave emphasized a different link between deficits and inflation. They sug-gest that the Federal Reserve purchases government bonds when the Trea-sury sells bonds, thus increasing high-powered money, the money supply,and the price level. The Federal Reserve might behave this way, for exam-ple, because it is attempting to hold down interest rates on governmentsecurities when deficits occur.Recently, Barro (1978, 1979) has put forward a hypothesis that deficitsare a result of inflation, rather than inflation being a result of deficits. Thegovernment deficit is the change in the nominal value of outstanding gov-ernment bonds. If the anticipated inflation rate increases, then the nomi-nal value of bonds must increase, i.e., the government will run a deficit, tokeep the same anticipated real amount of bonds.All three of these possible connections between government deficitsand inflation are consistent with the observed positive correlation of defi-cits and inflation. The implications, however, are strikingly different con-