STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE
INFLATION OF THE 1970’S
CHRISTOPHER A. SIMSA BSTRACT. The inﬂation of the 1970’s in the US is often discussed as if the only typeof policy action that could have prevented the inﬂation were monetary policy actions
and the only type of policy errors that might have induced the inﬂation were monetary policy errors. Yet ﬁscal policy underwent dramatic shifts in the 70’s and economic theory makes clear that in an environment of uncertainty about future ﬁscal
policy, monetary policy instruments may lose potency or have perverse effects. This
paper documents the vagaries of ﬁscal policy in this period and argues that people
at the time must have been uncertain about ﬁscal policy’s future course. It also laysout a theoretical framework for understanding the effects of ﬁscal uncertainties onmonetary policy and shows that ﬁscal variables have predictive value in dynamic
models, even if traditional monetary policy indicators are included in the system.

Note: This paper is still under construction.
I. T HE THEORY OF FISCAL AND MONETARY POLICY INTERACTION
It is a standard result in equilibrium models that recognize the government budget constraint as part of the model (sometimes called “ﬁscal theory of the price level”
or “FTPL” models) that when rational, forward-looking agents believe that newly issued nominal government debt is only partially backed by future taxes, debt issue
is inﬂationary. Furthermore, in such models, with such beliefs about future policy,
Date: May 23, 2008.
This research was supported by NSF grant SES 0350686.
1

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

2

policy-generated increases in the interest rate increase, rather than reduce, the inﬂation rate. The behavioral mechanisms underlying these results are fairly easy tounderstand. Increases in nominal debt in the hands of the public that are not accompanied by any increase in expected future tax liabilities or by any increase in theprice level leave the public with apparently increased wealth, which they will try
to spend, until price increases erode their wealth or expectations about future taxes
or economic growth make them scale back spending. In these circumstances, anincreased nominal interest rate ﬂows directly through to increased nominal government spending. In a ﬂexible price model, the monetary authority loses any ability
to affect the price level, as interest rate increases increase the rate of expansion of
nominal government debt without any restrictive effect on spending plans.
There are some high-inﬂation countries and time periods in which simple ﬂexprice models like these capture much of what goes on in monetary-ﬁscal interactions.
Interest rates are high, interest expense is a major part of the government budget,and monetary policy-makers are acutely aware that increases in interest rates arelikely to increase the rate of issue of nominal debt. However in the US in the 1970’s
these effects were smaller and more indirect. The eventual paper will lay out thesimple ﬂex-price models that already exist in the literature and (I expect, or at leasthope) will include a model with stickiness in which the monetary authority retains
the ability to generate recession or accelerate recovery even though it loses control
of trend inﬂation.

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

3

II. F ISCAL POLICY IN THE 1970’ S
From the point of view of FTPL models the most natural single measure of ﬁscal
stance is the primary surplus1 as a proportion of total outstanding debt. It must overtime approximately average out to the real rate of return on other investments.2 Figure 1 shows this ratio. Note that most of the time the US has run primary surpluses,
as expected, with the ﬁrst period of large, sustained primary deﬁcits beginning in
1975. This was the Ford tax cut and tax rebate. For one quarter, the primary deﬁcit
was at an annual rate of 20% of the outstanding market value of debt — a level not
approached before or since in the period since 1950 — and the deﬁcit persisted athigh levels for a couple of years thereafter. The Reagan deﬁcits of the early 80’s also
correspond to a period of sustained primary deﬁcits, thought the rate never reachedthat of the Ford tax rebates.
People acquiring the debt that was being issued in this period had to be expecting that primary surpluses would eventually again become the norm, but it seems
farfetched to suppose that they would have thought there was some simple rule,
based on historical behavior patterns, that would allow prediction of when and how
primary surpluses would re-emerge.
1

The primary surplus is revenues minus expenditures other than interest payments. It represents thenet payments to holders of bonds, both through interest and retirement of outstanding debt.
2

Strictly speaking, a weighted average of future primary surpluses divided by the current debt

must match the discount rate, so that if primary surpluses are growing, the ratio of current primary
surplus to current debt could be below the discount rate. But if primary surpluses and real investment
returns grow at the same rate, it will remain true that the primary surplus over debt must on average
match the ratio of current earnings to investment values.

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

4

−0.1

0.0

PriDef2ByB

0.1

0.2

Primary Deficit / Federal Debt

1950

1960

1970

1980

1990

2000

Time

F IGURE 1.

As remarkable as the huge spike in the primary deﬁcit in 1975 is the period ofsustained and growing primary surpluses in the latter part of the 90’s during the
Clinton administration. How do we account for these swings in ﬁscal stance? I’m
not sure there is any model that explains these swings, but it is interesting to look at
Figure 2. Figure 2 shows interest expense as a fraction of total expenditures for the
US. Until the early 80’s, interest expense was a small fraction of the budget, generally
well under 5%. But in the early 80’s it shot up to 20% of the budget and stayed there
for several years. It seems plausible that the ﬁscal discipline of the early Clinton
years may have been engendered in part by these budget realities having forced

5

0.15
0.10

IntExpByTotalR

0.20

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

1950

1960

1970

1980

1990

2000

Time

F IGURE 2. US Federal Government interest expense as proportion of
total expenditures
Congress to recognize that its ability to tax and spend was increasingly limited byrising interest costs.

III. M ODELS
III.1. A globally soluble model. The ﬁrst model is a simple ﬂex-price model ofan endowment economy, with functional forms chosen for convenience. It can besolved analytically, which allows us to see how explosive time paths for prices ormoney may, or may not, be excludable as competitive equilibria. Its purpose here
is to illustrate how in principle such existence and uniqueness issues should be resolved, to show that explosive equilibria can exist, and to provide an example inSTEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

6which an interest-rate-rule policy that satisﬁes the Taylor Principal (more than onefor-one eventual response of the policy rate to inﬂation) can be consistent with aunique equilibrium in which inﬂation explodes — even though there is a monetary
policy (ﬁxed money stock) that could rule out such equilibria.
The consumer’s problem is
[
max E

]

∞

∑ βt log Ct s.t.

(1)

t=0

Ct (1 + γvt ) +Bt + Mt
R B + Mt−1
= t−1 t−1
+ Yt + gt
Pt
Pt
vt =

Pt Ct
Mt

(2)
(3)

Monetary and ﬁscal policy are characterized by
Rt = β

−1

(

Pt Ct
Pt−1 Ct−1)θ

Bt + Mt
R B= t−1 t−1 + gt
PtPt
g t = g0 − φ

Bt−1
+ εt
Pt−1

Taylor Rule(4)

Gov’t Budget Constraint(5)

Fiscal Policy(6)

The Taylor rule equation, if logged, would look a lot like standard policy rules in
the literature. except that it constrains the coefﬁcients on inﬂation and output growth
to be identical. This constraint is to allow easy solution of the model.
The ﬁrst order conditions of the consumer, together with the other equations, produce
Rt = (1 − γv2t )−1(1 − γv2tβ(7))1−1/θ
Zt = Et Zt+1

(8)

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

Zt =(1 − γv2t )1/θ
1 + 2γvt

7(9)Note that Zt is monotone decreasing in vt . (8) has a solution with constant Z (andhence constant v) and is locally unstable if θ > 1 (the Taylor principle). We treat Yt
and ε t as i.i.d.
But can we rule out the locally unstable paths as equilibrium solutions? The paths
in which Z increases, and hence v decreases, can be ruled out. Once Z goes above
its steady state, equilibrium requires that it be unbounded above, but this cannot
happen even with v → 0, as can be seen from (9)The paths in which Z decreases, and hence v increases, cannot be ruled out. On
these paths, v approaches a ﬁnite upper limit as Z → 0, while R and Pt /Pt−1 approach inﬁnity. No feasibility constraint is violated if such a path persists forever,with ever accelerating inﬂation. This reﬂects the fact that agents in this model willhold positive real balances even if they know that they will lose all their value next
period.
The stationary equilibrium has R, M, PC and PY constant. We have not used thegovernment budget constraint or the ﬁscal rule. They simply determine a stationary
time path for government debt. What if policy were not a Taylor-principle Taylor
rule, but instead Rt = β−1 , i.e. a pure interest rate peg? What if, further, ﬁscal
policy were to make the primary deﬁcit (in equilibrium a surplus, if debt is positive)
exogenous, but following the same stochastic process (as a function of Yt and ε t ) as
in the Taylor-principle Taylor rule? Equilibrium with this policy combination resultsin exactly the same stochastic process for the variables in the model.

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

8While the Taylor-principle Taylor rule equilibrium price level we derived is notunique, this interest-rate peg equilibrium does deliver a unique price level. The
unstable equation is no longer the Z equation, but the government budget constraint. Deﬂationary deviations in which real debt explodes upward are ruled out
by transversality. Inﬂationary deviations in which real debt shrinks toward zero are
ruled out as infeasible from the viewpoint of private agents — they would see themselves as having insufﬁcient resources, in real bonds and discounted present valueof Y, to support both the SRC level of C and the discounted value of current andfuture taxes gt , so they would reduce their demand, reduce prices, bring the pricelevel back to the equilibrium path.
Leeper’s analysis of local uniqueness of stable paths suggests that no equilibrium
may exist when active monetary policy (interest rate highly responsive to inﬂation) is
combined with active ﬁscal policy (surplus unresponsive to the level of the debt). But
in this model, a unique equilibrium exists even when we combine an exogenously
ﬁxed primary surplus with a Taylor-principle Taylor rule. The result is (except for aknife-edge special case) a unique, explosive, equilibrium. A shock to the policy rulethat lowers the coefﬁcient on inﬂation reduces inﬂation and its rate of growth.
There is a way for the monetary authority to end the explosiveness: Lower theinterest rate and keep it ﬁxed. Here the ﬁscal authority cannot necessarily end the
explosiveness by switching to a passive ﬁscal policy, because that leaves the equilibrium non-unique.

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

9

If the monetary authority follows a ﬁxed-M or ﬁxed-M-growth rule, there is noequilibrium with active ﬁscal policy and passive ﬁscal policy delivers a unique equilibrium. The reason is that in this case, as inﬂation explodes, eventually real balances
reach a level such that, with ﬁxed M and prices expected to grow greatly, next period’s real balances would have to shrink below the minimum level that agents arewilling to hold. Since this implies money will be more in demand, and hence morevaluable, than the explosive path implies, it will raise the value of money this period,and hence unravel the equilibrium as we work backward in time.
III.2. A very simple FTPL model. To ﬁx ideas before we take up sticky price models,
we begin with a bare-bones ﬂexible-price, cashless-economy FTPL model with only
instantaneous short government debt:
M policy :Fisher? :Govt. Budg. Cnstr. :Fiscal policy :ṙ = −γ(r − ρ) + θ ṗ + ε m(10)r = ρ + ṗ(11)ḃ = −b ṗ + rb − τ(12)τ̇ = ε τ .

(13)

The starred equation is forward-looking. τ is the primary surplus, and the ﬁscal policy equation is saying that the primary surplus evolves exogenously, not responding
to the real value of the debt. It is important to note that the coefﬁcient of b on theright-hand side of the GBC (equation (12)) is r − ṗ, the ex post real rate of return on
government debt, not ρ = r − ṗˆ , where ṗˆ is the right-derivative at t of the expected
future path of prices. We assume in this ﬁrst model that the real interest rate ρ is an
exogenously given constant. Because τ in this model does not grow exponentially,

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

10

the government budget constraint can be solved forward to yield bt = Bt /Pt = τt /ρ.
Because there is only one asset, nominal debt, the amount of nominal debt outstanding at t, Bt , is ﬁxed by history, so the B/P = τ condition uniquely determines theprice level at any date. Substituting (11) into (10) to eliminate r produces the following equation in p:p̈ˆ = −γ ṗˆ + θ ṗ + ε m .

(14)

If θ > γ, this equation is unstable, so expected future inﬂation rates explode exponentially upward or downward, unless ṗ ≡ 0. If instead θ < γ, the equation isstable and the model has a unique, stable solution. When the equation is unstable,
the model may still have a unique equilibrium solution. The question is whether we
can rule out explosive time paths for inﬂation. Note that we have already used theassumption that real debt, the only asset, has a path that does not explode exponentially, and this uses up the implications of transversality. Explosive inﬂation paths
would coincide with non-explosive real wealth and (implicitly) constant income andconsumption. Of course these paths would be accompanied by, indeed in some sense
can be seen as produced by, a ﬁscal policy that runs exploding conventional deﬁcits
as the inﬂation proceeds. This is required to maintain a constant primary surplus asinterest expense explodes.
The combination of θ > γ monetary policy with the ﬁscal policy of (13) (Active
Money/Active Fiscal in the terminology of Leeper (1991)) as a permanent conﬁguration may be implausible, even if it does constitute an equilibrium system. It seems
likely that people would at least contemplate the possibility that the ﬁscal authorities would cease expanding the conventional deﬁcit along such a path, or that the

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

11

central bank would at some very high interest rate recognize the futility of futurerises (and that the rises were themselves producing the inﬂation, by expanding theconventional deﬁcit). It would be interesting to consider cases where the public has
evolving beliefs about when and how the active/active conﬁguration will be abandoned. But we focus attention here on the case where inﬂation is stable, or very
slowly exploding, i.e. θ < γ, or θ/γ slightly above one.
In this case a permanent upward shift in τ (a δ-function shock to ε τ ) makes theprice level jump downward and has no other effect. A δ-function shock to ε m makes
both ṗˆ and r jump upward by equal amounts, after which both decay back toward 0
and ρ exponentially, as e−(γ−θ)t . In other words, monetary contraction has no effecton inﬂation, except to increase it.

III.3. A New Keynesian style model of boomerang monetary policy. While thisstark model is instructive, it is unrealistic in assuming perfectly ﬂexible prices, andalso importantly in assuming that all government debt is instantaneously short debt.
With inertial prices, actions that might in a ﬂexible-price model produce downward jumps in the price level might be expected instead to produce recessions andsmoother declines in the price level or the inﬂation rate. With long debt, the requirement that the real value of government debt match the present value of future
primary surpluses can be met by jumps in the interest rate, which changes the valueof outstanding long debt even if the price level does not change.
To get realistic dynamics, we need to make consumers prefer smooth consumption
paths, which we do by adding a penalty on the squared derivative of consumption
to the utility function. Finally we need to recognize that actual primarily surpluses

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

12respond automatically to the business cycle. To reﬂect that, we add a term making
the primary surplus depend positively on the level of output. (It actually appears as
making the growth of the primary surplus depend on the growth of output.)
Below is a model that adds these elements.

M policy :Fisher? :IS? :Govt. Budg. Cnstr. :term struct.? :Phillips curve? :Fiscal policy :habit? :ṙ = −γ(r − ρ̄) + θ ṗ + φċ + ε m(15)r = ρ + ṗ

(16)

ρ=−

λ̇
+ ρ̄ + ε r
λ

(17)

ȧ
ḃ = −b ṗ − b + ab − τ̄ − τa(18)

r = a − ȧ/a(19)p̈ = β ṗ − δc − ε pc(20)τ̇ = ω ċ + ε τ(21)

λ = e−σc + ψ(c̈ − ċ2 )e−c

(22)

Starred equations again are forward-looking, which means, since for the time being all shocks are white noise, that ε r and ε pc have no effect. a is the consol rate, i.e.
one over the price of a consol yielding a one-dollar per period permanent ﬂow. b is
the real value of the government debt, i.e. B/(aP), where a is the consol rate, P is theprice level, and B is the number of outstanding consols. λ is the Lagrange multiplieron the consumer’s budget constraint, which depends on both consumption and its
rate of change.

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

13

Figures 3 and 4 display the responses of this system to monetary and ﬁscal deltafunction shocks. The parameter values used in generating these graphs were

γ

θ

φ

σ

ρ̄

τ̄

β

δ

0.50 0.40 0.75 2.00 0.05 0.10 0.10 0.20

ω

ψ

1.00

2.00

[Note: These impulse responses change — not in sign, but shape, when θ > γ. At
the conference I will also have an example of these responses for the θ > γ case.]
The parameter τ̄ does not appear in the equation system. It is the value of τ aroundwhich the model was linearized, which can be chosen arbitrarily because τ is nonstationary. The variable labeled “w” in the graphs is, in an unfortunate choice ofnotation, ṗˆ , the inﬂation rate.
The point here is that in this model, though we are still in an “active ﬁscal, passivemoney” equilibrium, monetary contraction still has powerful effects, in the expected
directions, on both real activity and inﬂation. The fact that monetary policy does
not control the long run rate of inﬂation shows up in the behavior of the responseof inﬂation w. After initially dropping, The inﬂation rate rises back above its steadystate level by as much as it initially fell, and the rise is more sustained than the initial
drop. This is the “stepping on a rake” phenomenon: Apparently effective measures
to reduce inﬂation come back, after a delay, to produce precisely the opposite of thedesired effect.
The expansionary ﬁscal shock3, shown in Figure 4, creates a boom in consumption
and an upward jump in the inﬂation rate. Monetary responds by increasing the3This is a negative shock to ε .
τSTEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

14

a

0.02
0.00

w

0.8

0.05 −0.10
−0.10

tau

0.0 −0.25

cc

1.5 −0.6 −0.4 −0.2
1.0

lam

0.0

0.5

rho

0.4
0.4
0.0
0.2

p

0.0
0.05−0.2

c

−0.10
−0.25
0
−4 −3 −2 −1

b

0.06

0.6
0.2

r

1.0

0.10

Responses to Monetary Shock

0

5

10

15

0

Time

5

10

15

Time

F IGURE 3.
interest rate, bringing the output boom and the increased inﬂation to an end. But theﬁscal shock has permanently changed the price level and has ﬁnanced the increased
debt issue via delayed, but unanticipated at the time of the ﬁscal shock, inﬂation.
IV. E STIMATION
It would be a good idea to ﬁt the model of the preceding section to the data, atleast roughly4, to see if parameter values that produce the behavior shown in ﬁgures
3 and 4 are supported by the data. One can’t be too optimistic about success with
this, however, because the model is based on an assumption that current behavior of
4

Perhaps using it to generate a prior for a structural time series model, as in DelNegro, Schorfheide,

Smets, and Wouters (2007) or Sims (2006).

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

15w−0.4 0.3

0.5

−0.4

tau

−0.7

4

cc

0.4

0.4

0.0
−1.0
−2.0

lam

−18 −16 −14 −12 0.0

b

0.2

c

0.6 0

0.8−1.02p6

8 −0.8

rho

0.7

0.0

0.10

0.20

a

0.4
0.2

r

0.6

Responses to Fiscal Shock

0

5

10

15

Time

0

5

10

15

Time

F IGURE 4.

the monetary and ﬁscal authorities and the public’s expectations about future policy
behavior are the same, and that both are unchanging. Part of the point of the graphs
in the early sections of the paper is that it is unrealistic to suppose that people ingeneral, and bond market participants in particular, had a stable, accurate view ofﬁscal policy, because the policy behavior was apparently undergoing drastic shifts.
It is possible, though, to investigate what happens to a non-structural descriptivemodel of the joint behavior of aggregate time series when primary surplus divided
by market value of debt is added to the usual list of variables.
Shown in Figure 5 are responses of GDP, CPI, and the federal funds rate to a shockin the primary deﬁcit divided by market value of debt. The responses are non-trivial

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

16

and of the expected direction. In Figure IV we see that the responses to the part offederal funds rate shocks not correlated with the primary deﬁcit shocks also haveplausible shapes. If the primary deﬁcit variable is omitted from the VAR, the “pricepuzzle” — a positive initial response of prices to an interest rate shock — is present,
and including the primary deﬁcit variable has gotten rid of it. These results arehighly preliminary, however. There are no error bands on them, and they present an
obvious identiﬁcation problem — the primary deﬁcit tends to rise at the same timethat interest rates fall. Furthermore, it is difﬁcult to rationalize this simultaneity as
common response to the business cycle, since output does not move contemporaneously with the shock — it responds with a delay. It could be that the shock represents a common perception, either mistaken or based on information outside thiscollection of variables, that an expansionary policy move is necessary. Or it could
represent a tendency of monetary policy to accommodate ﬁscal shifts. A model withmore structure (i.e., more debatable assumptions) would be required to distinguishmonetary and ﬁscal policy effects.
R EFERENCES
D EL N EGRO , M., F. S CHORFHEIDE , F. S METS , AND R. W OUTERS (2007): “On the Fit
and Forecasting Performance of New Keynesian Models,” Journal of Business andEconomic Statistics, 25(2), 123–162.
L EEPER , E. M. (1991): “Equilibria Under ‘Active’ and ‘Passive’ Monetary And Fiscal
Policies,” Journal of Monetary Economics, 27, 129–47.
S IMS , C. A. (2006): “Making Macro Models Behave Reasonably,” Discussion paper,
Princeton University, Presented at a conference at the Swedish Riksbank.

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

0.020
0.010
0.004
0.002
0.004
−0.003FF−0.001

0.001
0.000

GDP.Real

0.008
0.000

Cons.Defl

0.000

PriDef2ByB

Response to PD Shock (ypfr)

5

10

15

Time

F IGURE 5.

20

17

STEPPING ON A RAKE: THE ROLE OF FISCAL POLICY IN THE INFLATION OF THE 1970’S

0.000−0.002 0.000−0.008 −0.004

Cons.Defl

0.000−0.005−0.003−0.006

GDP.Real
FF

0.004
0.000

PriDef2ByB

Response to R Shock (ypfr)

5

10

15

Time

20

18