Unconventional Fiscal Policy in Times of High Inflation

IMF Working Papers, September 1, 2023

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Authors: Mai Dao, Allan Dizioli, Chris Jackson, Pierre-Olivier Gourinchas, Daniel Leigh
Published: September 1, 2023
Series: IMF Working Papers
DOI: https://doi.org/10.5089/9798400251399.001

The surge in energy prices in 2022 was a defining factor behind the increase in euro area inflation.
“Unconventional fiscal policy” is defined as the set of fiscal measures, possibly expansionary, motivated by a desire to mute the effects of the increase in energy prices and to lower inflation.
These unconventional measures reduced euro area inflation by 1 to 2 percentage points in 2022 and may avoid an undershoot later on.
When nonlinearities in the Phillips curve are taken into account, the net effect is to reduce inflation by about 0.5 percentage points in 2021-24 and keep it nearer to its target.
About one-third to one-half of the reduction in 2022 reflects the direct effects of the measures on headline inflation; much of the remainder reflects the lower pass-through to core inflation.

Direct effect: fiscal measures directly dampened headline inflation through measures that offset energy price increases.
Pass-through effect: fiscal measures lowered the pass-through from energy prices to core inflation, accounting for a large share of the total reduction beyond the direct headline effects.
Demand channel: although the fiscal measures were deficit-financed, they had limited effects on raising inflation by stimulating demand.
Expectations channel: the measures modestly helped to stabilize longer-term inflation expectations.

Reduction in euro area inflation in 2022: 1 to 2 percentage points.
Net reduction in inflation when accounting for Phillips-curve nonlinearities (2021-24): about 0.5 percentage points.
Contribution breakdown in 2022: about one-third to one-half from direct headline effects; remainder from reduced pass-through to core inflation.
Length of paper: 62 pages.
Series and identifiers: Working Paper No. 2023/178; DOI: https://doi.org/10.5089/9798400251399.001; ISBN: 9798400251399; ISSN: 1018-5941.

In the euro area context in 2022, unconventional fiscal measures helped lower headline inflation without materially stoking demand-driven inflationary pressures.
These measures can help avoid later undershoots of inflation relative to target by keeping inflation nearer to target when nonlinearities in inflation dynamics are considered.
Implementing similar measures in different contexts carries risk:
- In the face of a more persistent increase in energy prices, similar measures would have caused a more persistent rise in core inflation.
- In a more overheated economy, similar measures would have caused a more persistent rise in core inflation.
The prospective decline in euro area inflation reflects partly “fortunate circumstances”: energy prices falling from their 2022 peaks, fading pass-through effects, and less economic overheating than in economies such as the United States.

Unconventional Fiscal Policy in Times of High Inflation, IMF Working Papers 2023, No. 178.