How Fiscal and Monetary Policy Greatly Contributed to the 2021-22 Inflation Spike

A couple of weeks ago, I illustrated how profit margins and corporate greed were not ultimately responsible for the inflation spike in the United States. I also covered other plausible causes that could be attributing to the unusually high inflation, ranging from labor shortages and supply chain shocks to the pandemic and COVID-related restrictions. Today, I would like to cover two types of government policy that played their major role in our current round of inflation: monetary and fiscal policy. 

Monetary policy is the set of actions set by the monetary authority, typically a central bank, to control money supply and spur economic growth. In the United States, that authority is exercised by the Federal Reserve Bank. While it is one of their mandates to keep inflation at 2 percent, the Fed has contributed to the inflation. The Federal Reserve's role in inflation can be expressed with the quantity theory of money (QTM). QTM posits that "the general price level of goods and services is proportional to the money supply in the economy." The formula looks like the following: 

MV=PQ

As the St. Louis Federal Reserve illustrates in its primer, M stands for money supply. V stands for velocity, or the rate at which people spend money. P is the general price level, whereas Q is the quantity of goods and services produced. One of the Fed's main policy decisions during the pandemic was to expanding monetary supply (FRED).

Not only did money supply skyrocket, the money velocity started to increase in the fourth quarter of 2020 (FRED).

Going back to the formula MV=PQ, the left side of the equation increased. That means the right side of the equation has to increase in order to match the left side, whether it is from either price increases or an increase of quantity of goods and services produced, or a combination of both. It theoretically could be caused by an increase of both P and Q. 

In practice, we have been dealing with and are still dealing with a supply chain crisis. This bottleneck makes it a lot more difficult for the quantity of goods and services to grow. The inability to expand output (Q) means that the increase of aggregate demand puts upward pressure on prices. In other words, expansionary monetary policy in an economy with constrained economic output results in inflation. 

Researchers at Johns Hopkins and the Federal Reserve Bank of Chicago admit that tightening monetary policy could have averted the inflationary pressures (Bianchi and Melosi, 2022). On top of this mess, the Fed kept interest rates at historic lows through 2021, which only seemed to boost consumer demand and keep prices increasing. 

To read more on how expansionary monetary policy caused high inflation in 2021 and not in 2008, you can read this report from the Fraser Institute (Globerman, 2021).

While monetary policy contributed to the inflation, the other major culprit is Congress. Fiscal policy is the usage of government spending in taxation in attempts to influence the economy, which is mainly the purview of Congress since it is the legislative branch. During the pandemic, there were multiple spending bills passed in the name of COVID relief. These spending bills were very much demand-side in nature, especially the economic stimulus payments. In December 2020, I expressed concerns of how the payments would spur consumer demand and were ultimately not necessary. It turns out that I was correct. Here is some research and expert analysis showing that the government's spending packages contributed to inflation: 

• Researchers at Johns Hopkins University and the Federal Reserve Bank of Chicago found that while the spending accelerated the economy, it also resulted in fiscal inflation (Bianchi and Melosi, 2022).
• Marc Goldwein of the bipartisan Committee for a Responsible Federal Budget acknowledged that we would still have had 2-3 percent inflation without the American Rescue Plan (ARP) Act. Goldwein stated that the ARP was adding fuel to the fire of inflation. Similarly, economists on the Left and Right estimated that the ARP contributed to 2-4 percentage points in inflation. 
• The Tax Foundation points out how in 2020-21, the United States had the second largest stimulus spending as percent of GDP ratio. To understand how fiscal policy attributed, you can read a draft of "The Fiscal Theory of the Price Level" by Hoover Institution scholar John Cochrane. 
• The Federal Reserve Bank of San Francisco shows that both the CARES Act under the Trump Administration and ARP increased disposable income higher relative to other countries. This led to core inflation (i.e., consumer prices minus food and energy) being higher in the United States relative to other countries (see below). The Bank estimated in March 2022 that the expansionary fiscal policy increased inflation by 3 percentage points (Jordà et al., 2022).

There is a lot going on here, so let's recap. The pandemic was the epicenter for this snafu. There was bound to be some economic disruption caused by the pandemic. COVID regulations exacerbated the economic impacts, especially when it came to economic output and supply of goods and services. Shutting down large swathes of the economy with lockdowns disrupted the ability to work and generated the loss of customers, thereby limiting supply of goods and services. In 2020, the Fed increases money supply in a way that made the quantitative easing of the Great Recession look tame. It miscalculated the supply chain bottlenecks, which put inflationary pressures on prices in the macroeconomy. 

In the meantime, economic stimulus payments boost consumer demand, which is the wrong thing to do when supply is much more of an issue than demand. The stimulus payments were burning a hole in the pockets of American consumers and they were just itching to spend more, in spite of the inflationary pressures caused by monetary policy. This is especially true of the American Rescue Plan since a) there was higher money supply, b) there was the CARES Act, c) more people were getting vaccinated, and d) businesses started to open again. 

Yes, there were multiple factors to create this debacle. But make no mistake: expansionary monetary policy and expansionary fiscal policy were major contributors to the inflation that we have been experiencing for over a year now.