Distortionary taxation and surprise inflation finance government spending. What determines this mix? Households dislike both, but the political costs of high taxes fall on FP, while those of high inflation fall on MP. [2/12]
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We can model the Fed & Treasury as playing a game, each concerned with minimizing their own policy outcomes' costs (taxes for the Treasury, inflation for the Fed) and pushing 🏛️ financing to the other. The less constrained one is, the more constrained the other must be. [3/12]
Institutional strength 💪: Do we inflate debt away or repay it using tax revenue? It depends who has more political clout. Relative institutional bargaining power determines how the govt. is financed. Strong Treasury → high inflation, strong Fed → high taxes. [4/12]
A key theoretical result 📜: optimal outcomes require the Fed to have significantly more bargaining power than the Treasury. Of course, a prerequisite for a strong central bank is an independent one. [5/12]
This bargaining approach lets us quantify power dynamics that were previously difficult to measure. US fiscal power rose 📈 in the 60s and fell 📉 in the 80s, and spiked again 📈 after COVID. [6/12]
External validation 👍: The model's implied fiscal power closely tracks data on hours Presidents spent meeting with Fed officials 🤝 from Dreschel (2024)! Fortunately, power can be measured even after hours data end in 2008. [7/12]
Post-COVID fiscal bargaining power was 10x higher than post-GFC levels. This helps explain why we saw 6.2% inflation after COVID vs just 1.8% after GFC, despite large fiscal stimulus in both crises. [8/12]
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