A Fiscal Theory of Trend Inflation

Francesco Bianchi, Renato Faccini and Leonardo Melosi

No 17690, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We develop a new class of general equilibrium models with partially unfunded debt to propose a fiscal theory of trend inflation. In response to business cycle shocks, the monetary authority controls inflation, and the fiscal authority stabilizes debt. However, the central bank accommodates unfunded fiscal shocks, causing persistent movements in inflation, output, and real interest rates. In an estimated quantitative model, fiscal trend inflation accounts for the bulk of inflation dynamics. As external validation, we show that the model predicts the post-pandemic increase in inflation. Unfunded fiscal shocks sustain the recovery and cause an increase in trend inflation that counteracts deflationary non-policy shocks.

JEL-codes: E30 E50 E62 (search for similar items in EconPapers)
Date: 2022-11
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