7/29/2019 inflation n fiscal deficit.docx

1/2

To analyse the impact, let us start with a basic question ; Does a Fiscal Deficit necessarily

lead to Inflation?

No. Generally, two arguments are given in order to link a high fiscal deficit to inflation. The

first argument is based on the fact that the part of the fiscal deficit which is financed by

borrowing from the central banks i.e Seigniorage (money creation) leads to an increase in themoney stock. Some economists hold the belief that a higher money created leads to inflation

i.e money generated brings higher purchasing power. However, two flaws in this argument

can be analysed. Firstly, in an economy with unutilized resources, output is held in check by

the lack of demand and a high fiscal deficit may be accompanied by greater demand and

greater output. Secondly, the speed with which money created follows purchasing power is

not constant and varies as a result of changes in other economic variables. Hence even if a

part of the fiscal deficit translates into a larger money stock, it need not lead to inflation.

Secondly, in an economy in which the output of some essential commodities cannot be

increased, the increase in demand caused by a larger fiscal deficit will raise prices. This will

lead to inflation. Even if some particular commodities are in short supply, rationing and

similar strategies can check a price increase.To have a different look at the same issue, we can state that both fiscal deficits and inflation

are related indirectly. For example, if the economy is hit by a recession, the deficit is likely to

rise because tax revenues fall. At the same time, monetary policymakers may lower interest

rates to combat the recession, an act that may subsequently lead to higher inflation. In this

case, though, deficits are not, per se, the cause of inflation. Rather, deficits and inflation are

both consequences of the recession.

Finally, if the economy is in a state which the proponents of this argument believe it to be in,

that is, with output constrained by supply rather than demand, then not just fiscal deficits but

any way of increasing demand is inflationary.

References:http://www.phil.frb.org/;

http://www.pide.org.pk/psde/25/pdf/AGM27/Attiya%20Con%202011.pdf;

http://www.idosi.org/mejsr/mejsr8(1)11/43.pdf

http://www.phil.frb.org/http://www.phil.frb.org/http://www.phil.frb.org/http://www.pide.org.pk/psde/25/pdf/AGM27/Attiya%20Con%202011.pdfhttp://www.pide.org.pk/psde/25/pdf/AGM27/Attiya%20Con%202011.pdfhttp://www.idosi.org/mejsr/mejsr8(1)11/43.pdfhttp://www.idosi.org/mejsr/mejsr8(1)11/43.pdfhttp://www.idosi.org/mejsr/mejsr8(1)11/43.pdfhttp://www.pide.org.pk/psde/25/pdf/AGM27/Attiya%20Con%202011.pdfhttp://www.phil.frb.org/

7/29/2019 inflation n fiscal deficit.docx

2/2