## Chapter 2: Inflation and Disinflation: What Role for Fiscal Policy? — Executive Summary

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### Overview
- Upsurge in inflation since 2021 described as "the sharpest in more than three decades."
- Chapter examines: multifaceted impact of inflation on fiscal variables and distribution of well-being; how fiscal policy can help curb inflation while supporting the vulnerable.
- Governments influence distribution of inflation costs via discretionary intervention and automatic indexation (pensions, transfers, public wages, tax thresholds).
- Surveyed international practices: pensions are indexed in nearly all advanced economies and about 40 percent of emerging market and developing economies; indexation of cash transfers to vulnerable groups and public wages varies considerably across countries.

### Immediate fiscal channels and effects
- Unexpected inflation redistributes between public and private sectors by eroding the real (inflation-adjusted) value of government debt; bondholders bear the brunt.
- For countries with debt exceeding 50 percent of GDP, each 1 percentage point surprise increase in inflation is estimated to reduce public debt by 0.6 percentage point of GDP, with the effect lasting over the medium term.
- These debt-reduction effects are smaller or negligible for countries with a large share of debt denominated in foreign currency.
- When inflation is expected, it is not associated with a decline in debt ratios.
- Deficit-to-GDP ratios initially decline as nominal values of output increase and the tax base rises, but such effects dissipate over time.
- Infographic points on immediate impacts of inflation on public finances:
  - "Nominal GDP increases with inflation lead to lower fiscal deficits and public debt as a ratio to GDP."
  - "The nominal tax base also grows with inflation (for example, value-added tax and profit tax)."
  - "If income tax brackets are not indexed to inflation, taxpayers may be pushed into higher tax brackets (bracket creep)."
  - "Primary expenditure does not usually move immediately with inflation. However, public expenditure can go up with inflation with a short delay via indexation of public goods and services (for example, public wage, social benefits, subsidies, pension, and medical expenses) to inflation."
  - "Interest payments on inflation-indexed bonds go up with inflation."
  - "Governments with more short-term debt (S) than long-term debt (L) face higher refinancing costs as investors ask for higher returns to compensate for expected inflation. They pay higher interest on foreign-currency-denominated debt (F) than on domestic-currency debt (D) when the currency depreciates due to inflation."

### Distributional effects on households (survey evidence)
- Household surveys used: Colombia, Finland, France, Kenya, Mexico, Senegal.
- Price acceleration period analyzed: second quarter of 2021 to second quarter of 2022.
- Three channels estimated for price acceleration effects:
  1. Real incomes (wages and pensions).
  2. Losses in net nominal assets.
  3. Faster-than-average price rises for the main goods and services consumed by a given group (for example, food prices).
- Key findings:
  - Changes in real income were the most important channel and differed the most across countries but less so across income groups.
  - Losses on net nominal assets were larger for older groups than for young adults in countries with sizable household credit markets (young adults often have outstanding mortgage debt).
  - During the period considered, the estimated impact of inflation on the poverty rate (prior to new policy measures in response) is about 1 percentage point in three countries in the sample (France, Mexico, Senegal).

### Fiscal policy, aggregate demand, and interaction with monetary policy
- Historical estimates: an increase in public spending of 1 percentage point of GDP led to an increase in inflation of 0.8 percentage point in the 1950–85 period and of 0.5 percentage point thereafter.
- Interpretation: the smaller post-1985 effect arguably stems from a more forceful response by central banks to rising inflationary pressure in the post-1985 era.
- Model analysis embedding inequality in incomes, consumption, and asset holdings finds:
  - A reduction in the fiscal deficit leads to a similar level of disinflation but requires a smaller increase in interest rates than when central banks act alone.
  - Deficit reduction combined with transfers to the poorest yields a smaller drop in total private consumption and a consumption path associated with less inequality across households.
  - These effects are even more important when public debt is high because fiscal restraint limits the rise in the cost of borrowing and reduces debt vulnerabilities.

### Policy recommendations and lessons for policymakers
- Although surprise inflation may occasionally offer some breathing room for debt ratios, attempts to keep surprising bondholders have historically proved futile or harmful.
- When reviewing automatic or discretionary indexation, policymakers need to decide which programs and groups to protect from income erosion while avoiding excessive indexation or other policies that make inflation more persistent. The impact of decisions about public wages (including choices regarding indexation) on private wage setting should also be carefully assessed.
- When considering new measures or reforms against the backdrop of significant inflation, policymakers should consider that different groups of households may already be experiencing sizable distributive effects.
- Fiscal policy—involving tough policy choices on what budget items to cut and which to protect or expand—can support monetary policy in the effort to bring down inflation while protecting those most affected by the cost-of-living crisis.

*Source: IMF staff analysis.*

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_Source: https://www.imf.org/-/media/files/publications/fiscal-monitor/2023/april/english/ch2execsum.pdf_