Fiscal Policy Can Help Tame Inflation and Protect the Most Vulnerable

IMF Blog, April 3, 2023

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Canonical URL: Fiscal Policy Can Help Tame Inflation and Protect the Most Vulnerable

Authors: Vitor Gaspar, Carlos Eduardo Goncalves, Paolo Mauro, Marcos Poplawski-Ribeiro
Published: April 3, 2023

Authors: Vitor Gaspar, Carlos Eduardo Goncalves, Paolo Mauro, Marcos Poplawski-Ribeiro
Publication date: April 3, 2023
Period studied: mid-2021 to mid-2022
Focus: Effects of (unexpected) inflation on well-being and public finances; role of fiscal policy in curbing inflation while protecting vulnerable households

Main finding: Unexpected inflation erodes the real value of government debt at the expense of bondholders.
Quantified effect: For countries with debt exceeding 50 percent of GDP, each percentage point of unexpected (“surprise”) increase in inflation reduces public debt by 0.6 percentage points of GDP, with the effect lasting for several years.
Persistence caveat:
- As inflation becomes persistent and better anticipated, it stops contributing to declining debt ratios.
- Deficit-to-GDP ratios initially decline as spending fails to keep pace with the rise in the monetary value of the economy’s output, but such effects fade even quicker.

Data sources: Public surveys of thousands of households in six economies: Colombia, Finland, France, Kenya, Mexico, and Senegal.
Three main channels through which inflation affected people:
- Consumption patterns
- Income from wages, pensions, or transfers
- Assets and liabilities (wealth channels)
Key survey-based findings:
- Faster rise in food prices relative to other prices hurt poor families disproportionately because food represents a higher share of their total consumption; this effect was most pronounced in low-income countries.
- Inflation eroded real incomes in commodity-importing countries, as wages across all income groups did not keep pace with prices.
- As inflation eroded the monetary value of assets and liabilities, families with negative net worth benefited at the expense of creditors, particularly in countries with developed financial and credit markets.
- Redistributive wealth effects were influenced by the age of the head of household: young families (which tend to be net borrowers) experienced gains through the wealth channels, whereas old households saw their wealth eroded.

Fiscal support for monetary policy:
- Fiscal policy affects aggregate demand and can support monetary policy in dealing with inflation.
- Historical statistical evidence for advanced economies: since 1985, reducing public expenditure by 1 percentage point of GDP lowers inflation by half a percentage point.
Model-based insights:
- The economic model used incorporates inequality in incomes, consumption, and asset holdings.
- When central banks act alone—without the support of fiscal policy—they need to hike interest rates substantially to fight inflation.
- Fiscal tightening makes it possible to increase interest rates by less to contain inflation.
Protecting the poor while tightening:
- To safeguard the poor—who benefit more from public services—tax hikes or cuts in lower-priority spending must be combined with larger transfers.
- This strategy is designed to result in no drop in consumption for the poor, and in a lower decline in overall consumption.

This blog is based on Chapter 2 of the April 2023 Fiscal Monitor: “Inflation and Disinflation: What Role for Fiscal Policy?”