Effects of inflation on fiscal policy and government expenditure



Effects of inflation on fiscal policy and government expenditure





Inflation can be described as the rate of increase in the general price of goods and services coupled with a decrease in purchasing power of currency. It exists when money supply exceeds goods and services that are available. High inflation can lead to economic recession, and therefore there the is the need for a country or an economy to come up with measures that would limit inflation and avoid deflation. Limiting inflation enhances smooth running of the economy. The following section presents the signs and causes of inflation as well as the effects of inflation on fiscal policy and the government expenditure.

Signs and causes of inflation

There are two main causes of inflation thus demand pull inflation and cost push inflation. Demand pull inflation is caused by increase in aggregate demand and often takes place when an economy is close to full employment of the available resources. When there is a high level of employment, then an increase in aggregate demand causes an increase in price level. At full employment level, companies set high prices for goods and services (Machlup, 1960). Moreover, the shortage of labor can lead to an increase in wage thus increasing the purchasing power of workers.

On the hand, cost push inflation is caused by aggregate increase in cost of production. This could be brought about by increase in price of raw materials, salaries and wages and other costs associated with production of goods and services. Trade unions engage in collective bargaining agreements whose outcome is the increase in wages hence pushing up the cost of production(Machlup, 1960). As a result, firms are forced to increase the price of goods and services to boost their profit margin thus leading to cost push inflation.  An example of a country that experienced cost push inflation is the United Kingdom. This occurred between 2011 and 2012 and was due to the depreciation of British Pound against the Euros. Besides, the imposition of high taxes on raw materials and other goods led to increased production costs (Kontonikas, 2004).

Other causes of inflation include currency inflation, credit inflation and deficit induced inflation. Currency inflation comes about when the government prints more money than what is needed. Credit inflation occurs when commercial banks give more loans as well as advances to people than what they need. Increase in credit leads to a rise in price level. Deficit induced inflation happens when the government forces the central bank to print more money to enable it cover the budget deficit. (Machlup, 1960).

Effects of inflation on fiscal policies and government expenditure

Fiscal policies are measures that governments use to enhance stability in the economy. These policies include the effects of taxes on output and the government expenditure. Fiscal policies and inflation can be transmitted through aggregate demand depending on the level of taxes and government expenditure. The effect of inflation of government spending can be explained by deficit-induced inflation and government budget. The main objective of increasing government expenditure is to stimulate economic growth. Economist argue that increasing government expenditure can lead to economic growth but it can also lead to high inflation if preventive measures are not in place.

The following graph shows the effect of expansionary fiscal policies





P1    AD2

AD 1

Y1    Y2    Real GDP

An increase in government spending increases prices from P1 to P2. The real GDP also increases from Y1 to Y2 due to increase in aggregate demand from AD1 to AD2. The high demand in the economy leads to inflation.

When central banks prints more money to finance government deficit, money supply in increased. An increase in money supply leads to inflation. However, to reduce the level of inflation, the government might be forced to cut or limit its expenditure (Samuelson & Solow 1960). This is an example of an anti-inflationary policy that can be adopted by the government. Price controls and rationing are devices that can also be used to reduce the level of inflation.

An increase in government expenditure might lead to an increase in the cost of production thereby driving up the rate of inflation. High inflation reduces the real interest rates when no restrictive monetary policies are put in place. Low cost of borrowing boosts investments, and these might increase aggregate output indirectly through inflation.

According to Keynes, fiscal policy drives an economy since an increase in government expenditure or reduction in tax generates a multiplier effect and increases aggregate demand for goods and services. When taxes are reduced, disposable income and the marginal propensity to consume increases. Producers can take advantage of high demand by increasing the price of goods and services, and as a result, there would be demand pull inflation (Samudram  & Vaithilingam, 2009).

Inflation problems complicate decision-making in the public sector. Fiscal policies which affect government revenue and spending are normally used to stabilize the economy. An increase in the rate of inflation leads to increase in the cost of the services offered by the government, the cost of investment as well as budgetary demands. In addition, when there is high inflation, the government tries to keep real expenditure constant. Although, problems associates with reducing the real term of commitments might be experienced.

During the 1970s in the United Kingdom, changes in prices made fiscal decision makers to alter the real level of expenditures. The high inflation rate was due to demand for higher wages. Since public workers demand higher wages, the budget was adjusted to meet this expense (Kontonikas, 2004). This shows that the fiscal policies implemented by a country should take into account the possible effects of inflation. A government needs to determine the expected level of inflation. If a high rate is inflation is expected to prevail in the future, there should be specific increases in expenditure. Additionally, raising taxes and cutting down expenditure would be necessary if the rate of growth of revenue is expected to fall.

The effect of inflation on annual government expenditure depends on several factors including the effect of inflation on interest rates, the sources as well as the cost of financing. It is less likely for a government to adjust the annual government expenditure at initial stage of inflation. Rapid adjustments of the budget estimates are made when constant inflation is experienced for a longer period.


To sum up, inflation is mainly caused by an increase in aggregate demand and increase in the cost of production. It can also be brought about by an increase in credit and money supply in the economy. Inflation affects fiscal policies that are adopted by the relevant authorities. Expansionary fiscal policies increase government deficit. A high rate of inflation creates the need to increase government spending to finance budget deficits. The government might be forced to spend more money to cater for unexpected changes in wages and others items. However, the government can reduce its expenditure to avoid inflation. On the other hand, taxes can also be increased to reduce disposable income. Hence, there will be a fall in demand for goods, prices will be reduced thereby limiting inflation.



Kontonikas, A. (2004). Inflation and inflation uncertainty in the United Kingdom, evidence from     GARCH modelling. Economic modelling, 21(3), 525-543.

Machlup, F. (1960). Another view of cost-push and demand-pull inflation. The Review of     Economics and Statistics, 125-139.


Samudram, M., Nair, M., & Vaithilingam, S. (2009). Keynes and Wagner on government     expenditures and economic development: the case of a developing economy. Empirical     Economics, 36(3), 697-712.

Samuelson, P. A., & Solow, R. M. (1960). Analytical aspects of anti-inflation policy. The     American Economic Review, 50(2), 177-194.

Machlup, F. (1960). Another view of cost-push and demand-pull inflation. The Review of     Economics and Statistics, 125-139.


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