Stefan Karlsson's blog: Fiscal Policy & Price Inflation http://stefanmikarlsson.blogspot.com/2010/05/fiscal-policy-pric...

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H A R D - H I T T I N G E C O N O M I C S C O M M E N TA R Y

ABOUT ME

STEFA N K A RL SSON
SWEDEN

I am an economist
currently working in
Server Sweden. I am an

not independent thinker, but generally

lean toward the Austrian school of
found economics. I have written for free
market think tanks and web sites such
Firefox as Timbro, Captus , Ludwig von Mises
Institute, The European Enterprise
can't find
Institute and Der Invest Informant.
Visit InformedTrades.com to learn to profit from Stefan's insight.
InformedTrades offers a growing catalog of free courses to help you V I EW M Y COM PLETE PROFI LE
learn to trade.

S A T U R D AY, M AY 2 9 , 2 0 1 0

Fiscal Policy & Price Inflation

With much of Europe (not just Greece, Spain and Portugal, but also for
PREVIOUS POSTS
example Britain, France and Italy) engaging in fiscal austerity
programms, one question that arises is what effect this will have on Venezuela's Economy Continues To
Decline
price inflation.
The Difference Between Outlays And
Expenses
Traditionally the view is that it depends on whether or not the central
bank also tightens monetary policy. If a central bank is monetizing That's The Spirit
deficits, and responds to a decline in the deficit by monetizing less, U.K. Fiscal Situation Deteriorating
then fiscal austerity will reduce inflation. If on the other hand the Further
central bank tries to inflate more to compensate for the expected drag Japanese Economic Boom Driven By
on growth caused by fiscal action, then it could increase price inflation. China
Basic Monetary Economics For The
This view is largely corrects, but in a way it begs the question of what Monetary Economic...
happens given a certain monetary policy. Or in other words, what Euro Debt Panic Will Have
happens if monetary policy is not changed at all?

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Stefan Karlsson's blog: Fiscal Policy & Price Inflation http://stefanmikarlsson.blogspot.com/2010/05/fiscal-policy-pric...

Deflationary Impact Upon...

In general, the effect will be to reduce price inflation. The reason for Matthew Yglesias Distort The Record
that is that a lower deficit will reduce direct spending on consumer About Denmar &...
goods, something which will lower their price. Meanwhile, by reducing Gold Rise Above €1,000
demand for loanable funds, fiscal austerity will lower interest rates and Detroit Starts To Destroy Homes
raise asset prices and the prices of capital goods.

However, this outcome presupposes two things. First of all, that fiscal
action do not have significant negative supply effects. If the effects on
supply is greater than the effects on demand, then price inflation will
not go down but in fact increase.

If on the other hand fiscal austerity have a positive supply effect, then
the inflation reducing effects from lower demand will be reinforced
further.

The main example of a supply-reducing fiscal austerity actions is higher

marginal tax rates (including increases in consumption taxes). Supply
increasing fiscal austerity action includes for example reduced
unemployment benefits and a higher retirement age.

Another thing which it depends on is to what extent the lower interest

rates caused by fiscal austerity will cause the currency to depreciate or
not. Generally this will be the effect, but it is uncertain just how great
the effect will be. If the currency depreciation is great enough, then
inflation might in fact increase as a result of fiscal austerity.

In the case of the euro area (or any other currency union, or group of
countries with fixed exchange rates), relative inflation within the euro
area will always be reduced (at least assuming that there isn't
significant supply reducing effects caused by tax increases) as a result
of fiscal austerity since there won't be any nominal exchange rate
movements within the euro area. Because the euro will probably
depreciate as a result of fiscal austerity, the net effect on inflation in
countries tightening fiscal policy will be uncertain, but it is certain that
it will raise inflation in countries that don't tighten fiscal policy.

POSTED BY STEFAN KARLSSON AT 5: 57 P M

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