Do Deficits Cause Inflation? A High Frequency Narrative Approach

Abstract
Do fiscal deficits cause inflation? We study high frequency movements in inflation expectations around the 2021 Georgia Senate election runoffs—which, according to narrative evidence, raised expected deficits. Using event studies and instrumental variables, we estimate that Democrat victory caused the market’s expected price level over ten years to increase by 0.76%. Our estimate suggests that overall, higher deficits in late 2020 and early 2021 increased the price level by 7.1%. Turning to mechanisms, nominal interest rates did not change at short horizons but rose at long horizons. We calibrate a three-equation New Keynesian model with bonds-in-utility to standard parameters, including the pre-2020 slope of the Phillips Curve. Feeding in the fiscal shock and the estimated response of interest rates, the model quantitatively accounts for the size and dynamics of expected inflation after Georgia—suggesting an important determinant of inflation has been the combination of loose fiscal and monetary policy. Joint with Stephan Hobler.