Fiscal financing regimes and nominal stability: an historical analysis

Theory predicts that inflation dynamics differ markedly according to the fiscal regime – in particular whether or not fiscal shocks are financed by changes in the discounted sum of real primary surpluses. This paper takes a narrative approach to the difficult task of identifying the regime. Narrative evidence on British policymakers’ stated fiscal objectives and financing plans shows that policymakers used fiscal policy to stabilise the public finances in the Gold Standard era but did not do so in the era of the Great Inflation (1960s-70s). These findings are supported by empirical evidence that expansionary fiscal shocks caused the primary balance to rise after a lag in the Gold Standard regime, but did not do so in the Great Inflation regime. The price level rose in response to these shocks in the Great Inflation regime, showing that unexpected inflation played an important role in stabilising the public finances in that era.