The Inflationary Risks of Expansionary Fiscal Policy

Drawing on an extensive literature, this paper examines the extent to which expansionary fiscal policy poses a challenge to containing inflation. It does so by assessing how inflation responds to shocks to the fiscal deficit and public debt, and by identifying the channels through which these effects operate in Latin American countries. The analysis finds that unanticipated fiscal deficits are associated with higher current and future inflation. Consistent with predictions from an open economy Phillips curve framework, output gaps widen, inflation expectations rise, and the real exchange rate depreciates—due to an increase in the risk premium—following a shock. Unanticipated public debt is also linked to higher inflation mainly through the output gap and exchange rate channels.