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Federal Reserve Bank of Cleveland
Table 1 Growth Rates for Equation of Exchange Variables
Peak to peak and trough to trough"
Velocity
growth,
percent

Money
growth,b
percent

Inflation,
percent

Period

Rate"

Differd
ence

Peak to peak
1953:IlQ-1957:lIIQ
1957:IIIQ-1960:IQ
1960:IQ-1969:lIIQ
1969:lIIQ-1973:IVQ
1973:IVQ-1980:IQ
1980:IQ-1981:IQ

2.5
1.9
2.6
5.2
7.6
10.3

-0.6
0.7
2.6
2.4
2.7

1.5
1.1
4.0
6.2
6.6
6.7

-0.4
2.9
2.2
0.4
0.1

3.1
3.7
2.8
2.6
3.7
4.2

0.6
-0.9
-0.2
1.1
0.5

2.2
3.0
4.2
3.5
2.7
0.9

0.8
1.2
-0.7
-0.8
-1.8

2.6
1.8
2.9
6.5
7.1
8.5

-0.8
1.1
3.6
0.6
1.4

1.3
1.6
4.2
6.1
6.7
8.1

0.3
2.6
1.9
0.6
1.4

3.7
3.8
3.0
2.5
4.2
0.8

0.1
-0.8
-0.5
1.7
-3.4

2.4
3.5
4.3
2.2
3.7
0.5

1.1
0.8
-2.1
1.5
-3.2

, Trough to trough
1954:I1Q-1958:IIQ
1958:1Q-1960:IVQ
1960:IVQ-1970:IQ
1970:IQ-1975:IQ
1975:IQ-1980:I1Q
1980:I1Q-1982:IQ

RateC

Differenced

Real output
growth,
percent

Rate"

Differd
ence

Rate"

Differd
ence

a. See Equation of Exchange, equation 2.
b. Money is defined as currency in circulation, demand deposits, and other checkable deposits (M-1Al
from 1960:IQ to 1982:I1Qand as currency in circulation plus demand deposits from 1953:I1Qto 1960:IQ.
c. Average annual percentage rate of growth.
d. Percentage point difference between percent rates of growth from one period to the next.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Board of Governors of
the Federal Reserve System.

more and more private-sector investment
opportunities
become unprofitable,
and
lenders become more and more cautious
about making loans. Unlike the private
sector, the government faces no interestrate constraint on its spending programs,
and Treasury debt carries essentially no
default risk. When credit is scarce, the
Treasury moves to the head of the credit
queue, squeezing some private borrowing
from the line, a phenomenon
known as
crowding out.
Most economists
acknowledge
that
crowding out occurs, but disagree about
its extent, the time frame over which it
occurs, and its importance for long-term
real growth. Many believe that in the long
run a dollar of Treasury borrowing displaces a dollar of private investment.
They argue that budget deficits are appropriate only during economic downturns
and that budget surpluses should be generated during economic recoveries so that
the budget is balanced over the business
cycle. Large deficits that persist over the

business cycle reduce the rate of private
capital accumulation;
consequently,
the
economy experiences the substitution of
slow-growth
public spending for more
rapid-growth
private spending.
Other
economists acknowledge that deficits could
result in a substitution of public spending
for private spending and allow that deficits
can influence real spending over the short
and medium term, but they contend that
deficits do not affect real economic growth
in the long term.

process and because governments
can
control their money stocks.
Over the past 30 years, changes in the
long-term rate of inflation appeared most
closely related to changes in the long-term
money-growth
rate (see table 1). When
long-term money growth accelerated (or
decelerated),
inflation nearly always accelerated (or decelerated).
Similar close
relationships in the appropriate directions
generally are not apparent when changes
in the rate of inflation are compared with
changes
in either long-term
velocity
growth or long-term real-output growth.
Changes in the long-term growth of velocity and changes in the long-term growth of
real output on occasion explain more of
the change in the rate of inflation than
changes in money-stock
growth. This is
particularly true during the most recent
periods;
however,
long-term
velocity
growth and long-term real output growth
have fluctuated within a much narrower
range than either long-term money growth
or inflation, and they frequently moved in
directions that did not contribute to the
movement in the inflation rate as shown in
equation 2. Consequently,
linkages between deficits and velocity growth and
between deficits and long-term real-output
growth are probably much less important
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland,OH
44101

for inflation than linkages between deficits
and money growth.
The monetary link between deficits and
inflation is also important, because longterm money growth is more directly under
the control of policymakers
than either
velocity or long-term real growth. Even if
persistent Treasury borrowing should raise
velocity or reduce long-term real growth,
the Federal Reserve System can undertake the necessary offsetting adjustments
to maintain price stability. In this sense,
inflation is ultimately the product of government policy. As indicated earlier, the
System's ability to conduct offsetting and
anti-inflation monetary policy is best preserved when the System is using monetaryaggregate targets instead of interest-rate
targets. For this reason the Federal Reserve's
October
1979 monetary-policy
change is an important and necessary antiinflation policy adjustment in an era when
Treasury borrowing to finance large and
persistent
federal deficits is placing upward pressure on interest rates.
Owen Humpage is an economist with the Federal
Reserve Bank of Cleveland.
The opinions stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Conclusion
This Economic Commentary has described a number of possible channels
through which large, persistent federalbudget deficits could influence the longterm growth of the money stock, velocity,
and real GNP and, hence, could cause
inflation. Of all the possibilities, the deficitinflation
linkages
operating
through
changes in the money-stock
growth rate
are particularly important because of the
unique role money plays in the inflation

Address Correction
Requested:
Please send corrected mailing label to the Federal
Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101.

November

1, 1982

Do Deficits Cause Inflation?
by Owen F. Humpage
When the Reagan administration
first
took office, it forecast federal-budget deficits of $45 billion for fiscal year (FY) 1982
and $23 billion for FY 1983, and it projected
a balanced budget by FY 1985. Fiscal year
1982, however, ended in September with a
record $110-billion deficit, and most budget
analysts now expect a deficit of approximately $170 billion to $180 billion in FY
1983. Moreover, the deficit could easily
remain above $100 billion through FY 1985
unless Congress cuts expenditures or increases taxes. The federal government must
finance these deficits by selling Treasury
securities either to the Federal Reserve System or to the public.
The prospects for large federal budget
deficits persisting over the next few fiscal
years have raised fears that the hardfought gains recently won against inflation
will be lost as the economic recovery gathers momentum. In the United States there
appears to be a long-term association between persistent budget deficits and inflation. Since FY 1960, there has been only
one year, FY 1969, when the federal
budget was not in deficit. The annual rate
of inflation, as measured
by the GNP
implicit price deflator, accelerated from a
1.0 percent to 2.0 percent range in the
early 1960s to approximately
9.0 percent
in both FY 1980 and FY 1981. The relationship between deficits and inflation,
however,
is sufficiently weak to raise
doubts about the claim that deficits cause
inflation. Between FY 1976 and FY 1979,
for example, the deficit narrowed by approximate~y $39 billion, while the rate of inflation increased by 3.0 percentage points.
This Economic Commentary explores
the possible channels through which deficits could cause inflation. Unless we can
conclusively identify channels of influence
running from deficits to inflation, we might
conclude that inflation causes deficits or

that some outside factor affects both deficits and prices simultaneously.
Equation

of Exchange

Inflation is a persistent rise in the overall
level of prices. It cannot exist without an
equally persistent
rise in the supply of
money or decline in the demand for money
that outpaces the growth of goods and
services. It is in this sense that inflation
often is described as "too many dollars
chasing too few goods."
Fisher's equation of exchange provides
a useful framework for analyzing inflation.
It is tautologically true that:
(1)

MV = PQ.

That is, the money stock (M) times the
velocity of money (V), or the rate at which
money changes hands, must equal the
price level (P) times real output
The
product of the last two terms, PQ, equals
nominal GNP. After expressing the elements of the equation in percentage rates
of change and rearranging the terms, it is
approximately true that:

«».

(2)

P%

=

M%

+

V% -

Q%.

Expressed in this manner and defined over
an appropriately
long time frame, the
equation is consistent with the earlier definition of inflation: inflation (P%) cannot
exist without an equally persistent rise in
the money supply (M%) or a decline in the
demand for money, evidenced by a rise in
velocity (V%) that outpaces the growth in
real output (Q%).
1. Throughout this article, the term money is defined narrowly as assets that function as a medium of
exchange and/or a temporary store of purchasing
power. Currency, travelers' checks, demand deposits, negotiable order of withdrawal accounts, and
time deposits are examples of assets that possess
these attributes.

If deficits cause inflation, they must
operate through one or more of the variables on the right-hand side of equation 2.
Deficits, therefore, either must increase
the money supply, raise velocity, or reduce
real long-term output growth if they are to
cause inflation.

Deficits and the Money Supply
The Federal Reserve System is responsible for conducting U.S. monetary policy,
and it exercises this responsibility primarily through its purchases and sales of U.S.
government
debt securities with private
securities dealers. When the System purchases government debt, for example, it
pays for the securities with funds that are
deposited in the securities dealers' bank
accounts. These funds become the cash
reserves of deposit institutions and the
basis for a much larger increase in the
money supply.2 When the System sells a
government-debt
security,
the money
stock contracts.
The Federal Reserve System owns nearly
16 percent of the total, outstanding, publicly held U.S. government debt. The percentage has decreased from a recent high
of nearly 23 percent in 1974 but has
increased, on balance, since at least 1960.3
Although the System holds a sizable share
of the Treasury's debt, it is under no legislative requirement to do so. The Treasury
recently maintained a limited direct borrowing privilege of less than $5 billion with
the System, but it seldom used this facility
and never to an economically significant
amount. As a practical matter, therefore,
there is no direct link between the budget
deficits and the money-supply process.
The linkage between Treasury borrowing to finance the deficit and monetary
policy, however, could be indirect, stemming from the Federal Reserve's concern
about high interest rates. When the Treasury borrows from the public to finance
2. When reserves are lent and relent in a fractional
reserve banking system, the initialincrease in reserves
is capable of supporting a much larger increase in the
money supply. See Lester V. Chandler, The Econom·
ics of Money and Banking, 6th ed., London: Harper
& Row, 1973.
3. Data from the Flow of Funds, Board of Governors
of the Federal Reserve System.

the budget deficit, interest rates tend to
rise, especially if economic activity is robust
and private credit demands are strong. If
the Federal Reserve attempts to offset
such interest-rate
increases by injecting
reserves into the banking system, an indirect link is forged between deficit spending
and money creation. Under such circumstances, deficits have an inflationary potential. The more closely the System attempts to maintain interest-rate
targets,
the stronger the inflation potential of the
budget deficit.
Throughout most of its post-World War
II history, the Federal Reserve System has
been acutely sensitive to high .interest
rates. Immediately after the war, the Federal Reserve keyed monetary policy to
maintaining low interest rates on Treasury
securities, a procedure left over from war
financing. Although the March 1951 Accord
with the Treasury relieved the System of
this responsibility,
the Federal Reserve
continued
to conduct monetary
policy
during most of the 1950s and 1960s with an
eye toward dampening interest-rate fluctuations. In the late 1960s and early 1970s,
this approach was loosened somewhat as
the importance of focusing policy on monetary aggregates became more widely appreciated; yet, it was not until October
1979 that the Federal Reserve shifted its
day-to-day operating focus away from influencing interest-rate levels to managing the
stock of bank reserves as the primary
means of controlling money-stock growth.
Throughout most of the post-World War II
period, therefore,
interest-rate
targets
could have provided an indirect causal link
between
deficit spending,
monetary
growth, and inflation.
A correlation
between federal-budget
deficits and money creation also would
exist if both the fiscal and monetary authorities conducted
their policies to reduce
swings in the business cycle. When business activity declines and unemployment
rises, tax receipts, especially those tied to
income and profits, automatically decline,
and spending for such entitlement
programs as unemployment
compensation
and food stamps automatically increases.
The federal-budget
deficit automatically
rises. In addition to these automatic responses, Congress often introduces addi-

tional tax-reduction
and spending programs during recessions
to stimulate
recovery, and these programs add further
to the deficit. Business downturns and rising unemployment
also can induce the
Federal Reserve to inject additional reserves into the banking system to stimulate a business upturn. Under such circumstances the deficit could appear to be
monetized by the Federal Reserve System. Unlike the indirect interest-rate linkage, however, the correlation
between
money creation and deficit financing produced by policymakers' sensitivity to the
business cycle does not imply a causal link
between deficits and money-stock growth.
The relationship results because both the
U.S. monetary and fiscal authorities respond to fluctuations in a third factor, the
business cycle.
Although not unanimous in their findings, empirical studies indicate that increases in the money supply partially have
accommodated
federal-deficit
financing
during the 1960s and 1970s, but not during
the 1950s.4 A number of factors can explain this apparent shift during the early
1960s in the willingness of the Federal
Reserve
to accommodate
the federal
deficit. Between 1947 and 1960, the budget
was not persistently in deficit, but shifted
between surplus and deficit generally in
response to the business cycle and military
requirements.
The Treasury did not consistently put upward pressure on interest
rates during this period, especially during
the periods of economic growth. Only
after 1961 did the United States embark on
a virtually unaltered path of deficit financing. In addition, both monetary and fiscal
stabilization policies became more active
between
1960 and the mid-1970s and
focused more on the overall policy goal of
maintaining potential output instead of
smoothing business-cycle fluctuations. A
4. See, for example, Michael J. Hamburger and Burton Zwick, "Deficits, Money and Inflation," Journal of
Monetary Economics, vol. 7, no. 1 (January 1981),
pp. 141·50; W. Douglas McMillin and Thomas R.
Beard, "The Short- Run Impact of Fiscal Policy on the
Money Supply," Southern Economic Journal, vol.
47, no. 1 (July 1980), pp. 122-35; and Richard T.
Froyen, "A Test of the Endogeneity of Monetary
Policy," Journal of Econometrics, vol. 2, no. 2 (July
1974), pp. 175-88.

tendency to over-estimate the economy's
level of potential output could have introduced an inflationary bias into policy. During the 1960s there also was a general
belief that unemployment
was a more
serious problem than inflation; by accepting a bit more inflation, the nation could
attain a lower unemployment
rate. This
trade-off between inflation and unemployment proved to be illusory beyond the very
short run.

Deficits and Velocity
Even in the absence of a monetary accommodation,
large persistent
deficits
could cause inflation if they raised the
growth rate of the velocity of money (see
equation 2). An increase in the velocity of
money implies that individuals are holding
smaller cash balances for a given level of
GNP; looking at it from a slightly different
perspective, an increasing velocity implies
that a given rate of money-stock
growth
can support a larger rate of GNP growth.
Changes in velocity are associated with
changes in interest rates, availability of
money substitutes,
wealth, and innovations in the payments mechanism, such as
credit cards and electronic funds transfer.
Persistent deficits could raise the velocity
growth rate if the public viewed Treasury
securities as net wealth and if Treasury
securities were a close substitute for money.
When the federal government increases
expenditures or decreases taxes and issues
debt to finance these activities, the effect
on individuals' anticipated net wealth depends on whether they perceive a corresponding increase in their future tax liabilities to service and retire the newly issued
debt. If, for example, the federal government issues securities to cover a one-time
$lOO-billion deficit with maturity dates sufficiently short so that the current generation of taxpayers
expects to retire the
entire debt plus the interest due on the
debt through future taxes, the current
value of those future taxes would equal
$100 billion.f Financing federal expendi5. Ifthe government finances a $100-billiondeficit by
issuing one-year securities at the market interest rate
of 10 percent, the cost of retiring the debt is $110
billion. However, the present value (PV) of paying
$110 in one year with market interest rates at 10
percent is PV = 110/(1 + 0.10), or $100 billion.

tures through issuing debt would have no
different impact on taxpayers' net worth
than financing the same federal expenditures through current taxes. If, however,
debt were issued with a maturity sufficiently long so that the burden of retiring
the debt were shifted, at least in part, to
future generations, the current generation
might feel wealthier by the amount of the
federal expenditures for which it does not
pay. The outcome also depends on the
altruism of the current generation toward
its descendants.
The current generation
might not wish to saddle future generations with a large debt burden and consequently could leave bequests to retire the
debt. Higher interest rates induced by the
deficit would provide an added incentive
for such altruism. In effect, the current
generation would tax itself.6
The United States has added to its outstanding debt, through budget deficits, almost continuously since the early 1960s.
Opinions about whether this constitutes a
perceived increase in current-generation
taxpayers' net wealth differ. Many economists do not view the debt as a burden on
future generations; theoretically, the debt
can be rolled over indefinitely, postponing
the need to retire if indefinitely. Moreover,
federal debt outstanding
measured as a
ratio to GNP generally has fallen since the
early 1950s.
An increase in wealth increases individuals' demands for financial assets, including money, and for nonfinancial assets.
For deficits to raise velocity, assuming
Treasury debt is viewed as net wealth, the
demand for real assets must increase
more than the demand for money. This
could occur if the public also perceived
Treasury debt as a close substitute for
money. Treasury securities generally do
not function as a medium of exchange, as
do currency and checks; yet, Treasury
securities,
especially those with short
maturities, exhibit many qualities similar
to more broadly defined forms of money.

These qualities make Treasury securities
effective temporary stores of purchasing
power. Like most bank deposits, Treasury
debt entails little risk of loss from the
default of the issuer, and a well-developed
resale market for Treasury securities enables holders to convert Treasury securities into cash with little difficulty or risk of
loss. The liquidity of Treasury securities
makes them excellent, but not perfect,
substitutes for money. When the Treasury
issues debt securities, interest rates tend
to rise, increasing the opportunity cost of
holding idle cash balances relative to holding Treasury securities.

6. Although a deficit tends to shift the burden of
government finance to future generations, the current expenditures by government tend to confer
some benefits on future generations. Presumably,
\ the current generation would tax itself only to retire
the net burden of the debt.

7. Another measure of the nation's ability to supply
goods and services is potential GNP, which attempts
to gauge the amount of output the economy can produce at full-resource employment. Potential GNP
grew 3.8 percent from 1950-59, 3.7 percent from
1960-69, and 3.4 percent from 1970-81.

Deficits and Output
As suggested in equation 2, federal deficits could cause inflation if they restricted
the nation's ability to supply goods and
services, while leaving money and velocity
growth unaltered. This applies to the longterm growth of real output and not to
short-term
fluctuations
in the business
cycle; business-cycle declines in real output are associated with demand changes
and tend to reduce inflationary pressures.
While distinguishing between changes in
long-run trends and cyclical fluctuations in
output is difficult, the data in table 1 show
the growth of real output over similar
phases of the business cycle. Since 1970,
the long-term growth rate has slowed
somewhat. 7 Many factors could have
contributed
to the slowing ability of the
United States to supply goods and services, including the increasing relative importance of the service sector, changing
work-force demographics,
growing government regulations and taxation, increasing investment
for environmental
and
health requirements,
and rapidly rising
energy prices.
Deficits could also contribute
to the
long-term slowdown in U.S. real output
growth. As already mentioned, Treasury
borrowing to finance deficits tends to raise
interest rates, particularly when economic
activity is robust. As interest rates rise,

If deficits cause inflation, they must
operate through one or more of the variables on the right-hand side of equation 2.
Deficits, therefore, either must increase
the money supply, raise velocity, or reduce
real long-term output growth if they are to
cause inflation.

Deficits and the Money Supply
The Federal Reserve System is responsible for conducting U.S. monetary policy,
and it exercises this responsibility primarily through its purchases and sales of U.S.
government
debt securities with private
securities dealers. When the System purchases government debt, for example, it
pays for the securities with funds that are
deposited in the securities dealers' bank
accounts. These funds become the cash
reserves of deposit institutions and the
basis for a much larger increase in the
money supply.2 When the System sells a
government-debt
security,
the money
stock contracts.
The Federal Reserve System owns nearly
16 percent of the total, outstanding, publicly held U.S. government debt. The percentage has decreased from a recent high
of nearly 23 percent in 1974 but has
increased, on balance, since at least 1960.3
Although the System holds a sizable share
of the Treasury's debt, it is under no legislative requirement to do so. The Treasury
recently maintained a limited direct borrowing privilege of less than $5 billion with
the System, but it seldom used this facility
and never to an economically significant
amount. As a practical matter, therefore,
there is no direct link between the budget
deficits and the money-supply process.
The linkage between Treasury borrowing to finance the deficit and monetary
policy, however, could be indirect, stemming from the Federal Reserve's concern
about high interest rates. When the Treasury borrows from the public to finance
2. When reserves are lent and relent in a fractional
reserve banking system, the initialincrease in reserves
is capable of supporting a much larger increase in the
money supply. See Lester V. Chandler, The Econom·
ics of Money and Banking, 6th ed., London: Harper
& Row, 1973.
3. Data from the Flow of Funds, Board of Governors
of the Federal Reserve System.

the budget deficit, interest rates tend to
rise, especially if economic activity is robust
and private credit demands are strong. If
the Federal Reserve attempts to offset
such interest-rate
increases by injecting
reserves into the banking system, an indirect link is forged between deficit spending
and money creation. Under such circumstances, deficits have an inflationary potential. The more closely the System attempts to maintain interest-rate
targets,
the stronger the inflation potential of the
budget deficit.
Throughout most of its post-World War
II history, the Federal Reserve System has
been acutely sensitive to high .interest
rates. Immediately after the war, the Federal Reserve keyed monetary policy to
maintaining low interest rates on Treasury
securities, a procedure left over from war
financing. Although the March 1951 Accord
with the Treasury relieved the System of
this responsibility,
the Federal Reserve
continued
to conduct monetary
policy
during most of the 1950s and 1960s with an
eye toward dampening interest-rate fluctuations. In the late 1960s and early 1970s,
this approach was loosened somewhat as
the importance of focusing policy on monetary aggregates became more widely appreciated; yet, it was not until October
1979 that the Federal Reserve shifted its
day-to-day operating focus away from influencing interest-rate levels to managing the
stock of bank reserves as the primary
means of controlling money-stock growth.
Throughout most of the post-World War II
period, therefore,
interest-rate
targets
could have provided an indirect causal link
between
deficit spending,
monetary
growth, and inflation.
A correlation
between federal-budget
deficits and money creation also would
exist if both the fiscal and monetary authorities conducted
their policies to reduce
swings in the business cycle. When business activity declines and unemployment
rises, tax receipts, especially those tied to
income and profits, automatically decline,
and spending for such entitlement
programs as unemployment
compensation
and food stamps automatically increases.
The federal-budget
deficit automatically
rises. In addition to these automatic responses, Congress often introduces addi-

tional tax-reduction
and spending programs during recessions
to stimulate
recovery, and these programs add further
to the deficit. Business downturns and rising unemployment
also can induce the
Federal Reserve to inject additional reserves into the banking system to stimulate a business upturn. Under such circumstances the deficit could appear to be
monetized by the Federal Reserve System. Unlike the indirect interest-rate linkage, however, the correlation
between
money creation and deficit financing produced by policymakers' sensitivity to the
business cycle does not imply a causal link
between deficits and money-stock growth.
The relationship results because both the
U.S. monetary and fiscal authorities respond to fluctuations in a third factor, the
business cycle.
Although not unanimous in their findings, empirical studies indicate that increases in the money supply partially have
accommodated
federal-deficit
financing
during the 1960s and 1970s, but not during
the 1950s.4 A number of factors can explain this apparent shift during the early
1960s in the willingness of the Federal
Reserve
to accommodate
the federal
deficit. Between 1947 and 1960, the budget
was not persistently in deficit, but shifted
between surplus and deficit generally in
response to the business cycle and military
requirements.
The Treasury did not consistently put upward pressure on interest
rates during this period, especially during
the periods of economic growth. Only
after 1961 did the United States embark on
a virtually unaltered path of deficit financing. In addition, both monetary and fiscal
stabilization policies became more active
between
1960 and the mid-1970s and
focused more on the overall policy goal of
maintaining potential output instead of
smoothing business-cycle fluctuations. A
4. See, for example, Michael J. Hamburger and Burton Zwick, "Deficits, Money and Inflation," Journal of
Monetary Economics, vol. 7, no. 1 (January 1981),
pp. 141·50; W. Douglas McMillin and Thomas R.
Beard, "The Short- Run Impact of Fiscal Policy on the
Money Supply," Southern Economic Journal, vol.
47, no. 1 (July 1980), pp. 122-35; and Richard T.
Froyen, "A Test of the Endogeneity of Monetary
Policy," Journal of Econometrics, vol. 2, no. 2 (July
1974), pp. 175-88.

tendency to over-estimate the economy's
level of potential output could have introduced an inflationary bias into policy. During the 1960s there also was a general
belief that unemployment
was a more
serious problem than inflation; by accepting a bit more inflation, the nation could
attain a lower unemployment
rate. This
trade-off between inflation and unemployment proved to be illusory beyond the very
short run.

Deficits and Velocity
Even in the absence of a monetary accommodation,
large persistent
deficits
could cause inflation if they raised the
growth rate of the velocity of money (see
equation 2). An increase in the velocity of
money implies that individuals are holding
smaller cash balances for a given level of
GNP; looking at it from a slightly different
perspective, an increasing velocity implies
that a given rate of money-stock
growth
can support a larger rate of GNP growth.
Changes in velocity are associated with
changes in interest rates, availability of
money substitutes,
wealth, and innovations in the payments mechanism, such as
credit cards and electronic funds transfer.
Persistent deficits could raise the velocity
growth rate if the public viewed Treasury
securities as net wealth and if Treasury
securities were a close substitute for money.
When the federal government increases
expenditures or decreases taxes and issues
debt to finance these activities, the effect
on individuals' anticipated net wealth depends on whether they perceive a corresponding increase in their future tax liabilities to service and retire the newly issued
debt. If, for example, the federal government issues securities to cover a one-time
$lOO-billion deficit with maturity dates sufficiently short so that the current generation of taxpayers
expects to retire the
entire debt plus the interest due on the
debt through future taxes, the current
value of those future taxes would equal
$100 billion.f Financing federal expendi5. Ifthe government finances a $100-billiondeficit by
issuing one-year securities at the market interest rate
of 10 percent, the cost of retiring the debt is $110
billion. However, the present value (PV) of paying
$110 in one year with market interest rates at 10
percent is PV = 110/(1 + 0.10), or $100 billion.

tures through issuing debt would have no
different impact on taxpayers' net worth
than financing the same federal expenditures through current taxes. If, however,
debt were issued with a maturity sufficiently long so that the burden of retiring
the debt were shifted, at least in part, to
future generations, the current generation
might feel wealthier by the amount of the
federal expenditures for which it does not
pay. The outcome also depends on the
altruism of the current generation toward
its descendants.
The current generation
might not wish to saddle future generations with a large debt burden and consequently could leave bequests to retire the
debt. Higher interest rates induced by the
deficit would provide an added incentive
for such altruism. In effect, the current
generation would tax itself.6
The United States has added to its outstanding debt, through budget deficits, almost continuously since the early 1960s.
Opinions about whether this constitutes a
perceived increase in current-generation
taxpayers' net wealth differ. Many economists do not view the debt as a burden on
future generations; theoretically, the debt
can be rolled over indefinitely, postponing
the need to retire if indefinitely. Moreover,
federal debt outstanding
measured as a
ratio to GNP generally has fallen since the
early 1950s.
An increase in wealth increases individuals' demands for financial assets, including money, and for nonfinancial assets.
For deficits to raise velocity, assuming
Treasury debt is viewed as net wealth, the
demand for real assets must increase
more than the demand for money. This
could occur if the public also perceived
Treasury debt as a close substitute for
money. Treasury securities generally do
not function as a medium of exchange, as
do currency and checks; yet, Treasury
securities,
especially those with short
maturities, exhibit many qualities similar
to more broadly defined forms of money.

These qualities make Treasury securities
effective temporary stores of purchasing
power. Like most bank deposits, Treasury
debt entails little risk of loss from the
default of the issuer, and a well-developed
resale market for Treasury securities enables holders to convert Treasury securities into cash with little difficulty or risk of
loss. The liquidity of Treasury securities
makes them excellent, but not perfect,
substitutes for money. When the Treasury
issues debt securities, interest rates tend
to rise, increasing the opportunity cost of
holding idle cash balances relative to holding Treasury securities.

6. Although a deficit tends to shift the burden of
government finance to future generations, the current expenditures by government tend to confer
some benefits on future generations. Presumably,
\ the current generation would tax itself only to retire
the net burden of the debt.

7. Another measure of the nation's ability to supply
goods and services is potential GNP, which attempts
to gauge the amount of output the economy can produce at full-resource employment. Potential GNP
grew 3.8 percent from 1950-59, 3.7 percent from
1960-69, and 3.4 percent from 1970-81.

Deficits and Output
As suggested in equation 2, federal deficits could cause inflation if they restricted
the nation's ability to supply goods and
services, while leaving money and velocity
growth unaltered. This applies to the longterm growth of real output and not to
short-term
fluctuations
in the business
cycle; business-cycle declines in real output are associated with demand changes
and tend to reduce inflationary pressures.
While distinguishing between changes in
long-run trends and cyclical fluctuations in
output is difficult, the data in table 1 show
the growth of real output over similar
phases of the business cycle. Since 1970,
the long-term growth rate has slowed
somewhat. 7 Many factors could have
contributed
to the slowing ability of the
United States to supply goods and services, including the increasing relative importance of the service sector, changing
work-force demographics,
growing government regulations and taxation, increasing investment
for environmental
and
health requirements,
and rapidly rising
energy prices.
Deficits could also contribute
to the
long-term slowdown in U.S. real output
growth. As already mentioned, Treasury
borrowing to finance deficits tends to raise
interest rates, particularly when economic
activity is robust. As interest rates rise,

If deficits cause inflation, they must
operate through one or more of the variables on the right-hand side of equation 2.
Deficits, therefore, either must increase
the money supply, raise velocity, or reduce
real long-term output growth if they are to
cause inflation.

Deficits and the Money Supply
The Federal Reserve System is responsible for conducting U.S. monetary policy,
and it exercises this responsibility primarily through its purchases and sales of U.S.
government
debt securities with private
securities dealers. When the System purchases government debt, for example, it
pays for the securities with funds that are
deposited in the securities dealers' bank
accounts. These funds become the cash
reserves of deposit institutions and the
basis for a much larger increase in the
money supply.2 When the System sells a
government-debt
security,
the money
stock contracts.
The Federal Reserve System owns nearly
16 percent of the total, outstanding, publicly held U.S. government debt. The percentage has decreased from a recent high
of nearly 23 percent in 1974 but has
increased, on balance, since at least 1960.3
Although the System holds a sizable share
of the Treasury's debt, it is under no legislative requirement to do so. The Treasury
recently maintained a limited direct borrowing privilege of less than $5 billion with
the System, but it seldom used this facility
and never to an economically significant
amount. As a practical matter, therefore,
there is no direct link between the budget
deficits and the money-supply process.
The linkage between Treasury borrowing to finance the deficit and monetary
policy, however, could be indirect, stemming from the Federal Reserve's concern
about high interest rates. When the Treasury borrows from the public to finance
2. When reserves are lent and relent in a fractional
reserve banking system, the initialincrease in reserves
is capable of supporting a much larger increase in the
money supply. See Lester V. Chandler, The Econom·
ics of Money and Banking, 6th ed., London: Harper
& Row, 1973.
3. Data from the Flow of Funds, Board of Governors
of the Federal Reserve System.

the budget deficit, interest rates tend to
rise, especially if economic activity is robust
and private credit demands are strong. If
the Federal Reserve attempts to offset
such interest-rate
increases by injecting
reserves into the banking system, an indirect link is forged between deficit spending
and money creation. Under such circumstances, deficits have an inflationary potential. The more closely the System attempts to maintain interest-rate
targets,
the stronger the inflation potential of the
budget deficit.
Throughout most of its post-World War
II history, the Federal Reserve System has
been acutely sensitive to high .interest
rates. Immediately after the war, the Federal Reserve keyed monetary policy to
maintaining low interest rates on Treasury
securities, a procedure left over from war
financing. Although the March 1951 Accord
with the Treasury relieved the System of
this responsibility,
the Federal Reserve
continued
to conduct monetary
policy
during most of the 1950s and 1960s with an
eye toward dampening interest-rate fluctuations. In the late 1960s and early 1970s,
this approach was loosened somewhat as
the importance of focusing policy on monetary aggregates became more widely appreciated; yet, it was not until October
1979 that the Federal Reserve shifted its
day-to-day operating focus away from influencing interest-rate levels to managing the
stock of bank reserves as the primary
means of controlling money-stock growth.
Throughout most of the post-World War II
period, therefore,
interest-rate
targets
could have provided an indirect causal link
between
deficit spending,
monetary
growth, and inflation.
A correlation
between federal-budget
deficits and money creation also would
exist if both the fiscal and monetary authorities conducted
their policies to reduce
swings in the business cycle. When business activity declines and unemployment
rises, tax receipts, especially those tied to
income and profits, automatically decline,
and spending for such entitlement
programs as unemployment
compensation
and food stamps automatically increases.
The federal-budget
deficit automatically
rises. In addition to these automatic responses, Congress often introduces addi-

tional tax-reduction
and spending programs during recessions
to stimulate
recovery, and these programs add further
to the deficit. Business downturns and rising unemployment
also can induce the
Federal Reserve to inject additional reserves into the banking system to stimulate a business upturn. Under such circumstances the deficit could appear to be
monetized by the Federal Reserve System. Unlike the indirect interest-rate linkage, however, the correlation
between
money creation and deficit financing produced by policymakers' sensitivity to the
business cycle does not imply a causal link
between deficits and money-stock growth.
The relationship results because both the
U.S. monetary and fiscal authorities respond to fluctuations in a third factor, the
business cycle.
Although not unanimous in their findings, empirical studies indicate that increases in the money supply partially have
accommodated
federal-deficit
financing
during the 1960s and 1970s, but not during
the 1950s.4 A number of factors can explain this apparent shift during the early
1960s in the willingness of the Federal
Reserve
to accommodate
the federal
deficit. Between 1947 and 1960, the budget
was not persistently in deficit, but shifted
between surplus and deficit generally in
response to the business cycle and military
requirements.
The Treasury did not consistently put upward pressure on interest
rates during this period, especially during
the periods of economic growth. Only
after 1961 did the United States embark on
a virtually unaltered path of deficit financing. In addition, both monetary and fiscal
stabilization policies became more active
between
1960 and the mid-1970s and
focused more on the overall policy goal of
maintaining potential output instead of
smoothing business-cycle fluctuations. A
4. See, for example, Michael J. Hamburger and Burton Zwick, "Deficits, Money and Inflation," Journal of
Monetary Economics, vol. 7, no. 1 (January 1981),
pp. 141·50; W. Douglas McMillin and Thomas R.
Beard, "The Short- Run Impact of Fiscal Policy on the
Money Supply," Southern Economic Journal, vol.
47, no. 1 (July 1980), pp. 122-35; and Richard T.
Froyen, "A Test of the Endogeneity of Monetary
Policy," Journal of Econometrics, vol. 2, no. 2 (July
1974), pp. 175-88.

tendency to over-estimate the economy's
level of potential output could have introduced an inflationary bias into policy. During the 1960s there also was a general
belief that unemployment
was a more
serious problem than inflation; by accepting a bit more inflation, the nation could
attain a lower unemployment
rate. This
trade-off between inflation and unemployment proved to be illusory beyond the very
short run.

Deficits and Velocity
Even in the absence of a monetary accommodation,
large persistent
deficits
could cause inflation if they raised the
growth rate of the velocity of money (see
equation 2). An increase in the velocity of
money implies that individuals are holding
smaller cash balances for a given level of
GNP; looking at it from a slightly different
perspective, an increasing velocity implies
that a given rate of money-stock
growth
can support a larger rate of GNP growth.
Changes in velocity are associated with
changes in interest rates, availability of
money substitutes,
wealth, and innovations in the payments mechanism, such as
credit cards and electronic funds transfer.
Persistent deficits could raise the velocity
growth rate if the public viewed Treasury
securities as net wealth and if Treasury
securities were a close substitute for money.
When the federal government increases
expenditures or decreases taxes and issues
debt to finance these activities, the effect
on individuals' anticipated net wealth depends on whether they perceive a corresponding increase in their future tax liabilities to service and retire the newly issued
debt. If, for example, the federal government issues securities to cover a one-time
$lOO-billion deficit with maturity dates sufficiently short so that the current generation of taxpayers
expects to retire the
entire debt plus the interest due on the
debt through future taxes, the current
value of those future taxes would equal
$100 billion.f Financing federal expendi5. Ifthe government finances a $100-billiondeficit by
issuing one-year securities at the market interest rate
of 10 percent, the cost of retiring the debt is $110
billion. However, the present value (PV) of paying
$110 in one year with market interest rates at 10
percent is PV = 110/(1 + 0.10), or $100 billion.

tures through issuing debt would have no
different impact on taxpayers' net worth
than financing the same federal expenditures through current taxes. If, however,
debt were issued with a maturity sufficiently long so that the burden of retiring
the debt were shifted, at least in part, to
future generations, the current generation
might feel wealthier by the amount of the
federal expenditures for which it does not
pay. The outcome also depends on the
altruism of the current generation toward
its descendants.
The current generation
might not wish to saddle future generations with a large debt burden and consequently could leave bequests to retire the
debt. Higher interest rates induced by the
deficit would provide an added incentive
for such altruism. In effect, the current
generation would tax itself.6
The United States has added to its outstanding debt, through budget deficits, almost continuously since the early 1960s.
Opinions about whether this constitutes a
perceived increase in current-generation
taxpayers' net wealth differ. Many economists do not view the debt as a burden on
future generations; theoretically, the debt
can be rolled over indefinitely, postponing
the need to retire if indefinitely. Moreover,
federal debt outstanding
measured as a
ratio to GNP generally has fallen since the
early 1950s.
An increase in wealth increases individuals' demands for financial assets, including money, and for nonfinancial assets.
For deficits to raise velocity, assuming
Treasury debt is viewed as net wealth, the
demand for real assets must increase
more than the demand for money. This
could occur if the public also perceived
Treasury debt as a close substitute for
money. Treasury securities generally do
not function as a medium of exchange, as
do currency and checks; yet, Treasury
securities,
especially those with short
maturities, exhibit many qualities similar
to more broadly defined forms of money.

These qualities make Treasury securities
effective temporary stores of purchasing
power. Like most bank deposits, Treasury
debt entails little risk of loss from the
default of the issuer, and a well-developed
resale market for Treasury securities enables holders to convert Treasury securities into cash with little difficulty or risk of
loss. The liquidity of Treasury securities
makes them excellent, but not perfect,
substitutes for money. When the Treasury
issues debt securities, interest rates tend
to rise, increasing the opportunity cost of
holding idle cash balances relative to holding Treasury securities.

6. Although a deficit tends to shift the burden of
government finance to future generations, the current expenditures by government tend to confer
some benefits on future generations. Presumably,
\ the current generation would tax itself only to retire
the net burden of the debt.

7. Another measure of the nation's ability to supply
goods and services is potential GNP, which attempts
to gauge the amount of output the economy can produce at full-resource employment. Potential GNP
grew 3.8 percent from 1950-59, 3.7 percent from
1960-69, and 3.4 percent from 1970-81.

Deficits and Output
As suggested in equation 2, federal deficits could cause inflation if they restricted
the nation's ability to supply goods and
services, while leaving money and velocity
growth unaltered. This applies to the longterm growth of real output and not to
short-term
fluctuations
in the business
cycle; business-cycle declines in real output are associated with demand changes
and tend to reduce inflationary pressures.
While distinguishing between changes in
long-run trends and cyclical fluctuations in
output is difficult, the data in table 1 show
the growth of real output over similar
phases of the business cycle. Since 1970,
the long-term growth rate has slowed
somewhat. 7 Many factors could have
contributed
to the slowing ability of the
United States to supply goods and services, including the increasing relative importance of the service sector, changing
work-force demographics,
growing government regulations and taxation, increasing investment
for environmental
and
health requirements,
and rapidly rising
energy prices.
Deficits could also contribute
to the
long-term slowdown in U.S. real output
growth. As already mentioned, Treasury
borrowing to finance deficits tends to raise
interest rates, particularly when economic
activity is robust. As interest rates rise,

Federal Reserve Bank of Cleveland
Table 1 Growth Rates for Equation of Exchange Variables
Peak to peak and trough to trough"
Velocity
growth,
percent

Money
growth,b
percent

Inflation,
percent

Period

Rate"

Differd
ence

Peak to peak
1953:IlQ-1957:lIIQ
1957:IIIQ-1960:IQ
1960:IQ-1969:lIIQ
1969:lIIQ-1973:IVQ
1973:IVQ-1980:IQ
1980:IQ-1981:IQ

2.5
1.9
2.6
5.2
7.6
10.3

-0.6
0.7
2.6
2.4
2.7

1.5
1.1
4.0
6.2
6.6
6.7

-0.4
2.9
2.2
0.4
0.1

3.1
3.7
2.8
2.6
3.7
4.2

0.6
-0.9
-0.2
1.1
0.5

2.2
3.0
4.2
3.5
2.7
0.9

0.8
1.2
-0.7
-0.8
-1.8

2.6
1.8
2.9
6.5
7.1
8.5

-0.8
1.1
3.6
0.6
1.4

1.3
1.6
4.2
6.1
6.7
8.1

0.3
2.6
1.9
0.6
1.4

3.7
3.8
3.0
2.5
4.2
0.8

0.1
-0.8
-0.5
1.7
-3.4

2.4
3.5
4.3
2.2
3.7
0.5

1.1
0.8
-2.1
1.5
-3.2

, Trough to trough
1954:I1Q-1958:IIQ
1958:1Q-1960:IVQ
1960:IVQ-1970:IQ
1970:IQ-1975:IQ
1975:IQ-1980:I1Q
1980:I1Q-1982:IQ

RateC

Differenced

Real output
growth,
percent

Rate"

Differd
ence

Rate"

Differd
ence

a. See Equation of Exchange, equation 2.
b. Money is defined as currency in circulation, demand deposits, and other checkable deposits (M-1Al
from 1960:IQ to 1982:I1Qand as currency in circulation plus demand deposits from 1953:I1Qto 1960:IQ.
c. Average annual percentage rate of growth.
d. Percentage point difference between percent rates of growth from one period to the next.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Board of Governors of
the Federal Reserve System.

more and more private-sector investment
opportunities
become unprofitable,
and
lenders become more and more cautious
about making loans. Unlike the private
sector, the government faces no interestrate constraint on its spending programs,
and Treasury debt carries essentially no
default risk. When credit is scarce, the
Treasury moves to the head of the credit
queue, squeezing some private borrowing
from the line, a phenomenon
known as
crowding out.
Most economists
acknowledge
that
crowding out occurs, but disagree about
its extent, the time frame over which it
occurs, and its importance for long-term
real growth. Many believe that in the long
run a dollar of Treasury borrowing displaces a dollar of private investment.
They argue that budget deficits are appropriate only during economic downturns
and that budget surpluses should be generated during economic recoveries so that
the budget is balanced over the business
cycle. Large deficits that persist over the

business cycle reduce the rate of private
capital accumulation;
consequently,
the
economy experiences the substitution of
slow-growth
public spending for more
rapid-growth
private spending.
Other
economists acknowledge that deficits could
result in a substitution of public spending
for private spending and allow that deficits
can influence real spending over the short
and medium term, but they contend that
deficits do not affect real economic growth
in the long term.

process and because governments
can
control their money stocks.
Over the past 30 years, changes in the
long-term rate of inflation appeared most
closely related to changes in the long-term
money-growth
rate (see table 1). When
long-term money growth accelerated (or
decelerated),
inflation nearly always accelerated (or decelerated).
Similar close
relationships in the appropriate directions
generally are not apparent when changes
in the rate of inflation are compared with
changes
in either long-term
velocity
growth or long-term real-output growth.
Changes in the long-term growth of velocity and changes in the long-term growth of
real output on occasion explain more of
the change in the rate of inflation than
changes in money-stock
growth. This is
particularly true during the most recent
periods;
however,
long-term
velocity
growth and long-term real output growth
have fluctuated within a much narrower
range than either long-term money growth
or inflation, and they frequently moved in
directions that did not contribute to the
movement in the inflation rate as shown in
equation 2. Consequently,
linkages between deficits and velocity growth and
between deficits and long-term real-output
growth are probably much less important
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland,OH
44101

for inflation than linkages between deficits
and money growth.
The monetary link between deficits and
inflation is also important, because longterm money growth is more directly under
the control of policymakers
than either
velocity or long-term real growth. Even if
persistent Treasury borrowing should raise
velocity or reduce long-term real growth,
the Federal Reserve System can undertake the necessary offsetting adjustments
to maintain price stability. In this sense,
inflation is ultimately the product of government policy. As indicated earlier, the
System's ability to conduct offsetting and
anti-inflation monetary policy is best preserved when the System is using monetaryaggregate targets instead of interest-rate
targets. For this reason the Federal Reserve's
October
1979 monetary-policy
change is an important and necessary antiinflation policy adjustment in an era when
Treasury borrowing to finance large and
persistent
federal deficits is placing upward pressure on interest rates.
Owen Humpage is an economist with the Federal
Reserve Bank of Cleveland.
The opinions stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Conclusion
This Economic Commentary has described a number of possible channels
through which large, persistent federalbudget deficits could influence the longterm growth of the money stock, velocity,
and real GNP and, hence, could cause
inflation. Of all the possibilities, the deficitinflation
linkages
operating
through
changes in the money-stock
growth rate
are particularly important because of the
unique role money plays in the inflation

Address Correction
Requested:
Please send corrected mailing label to the Federal
Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101.

November

1, 1982

Do Deficits Cause Inflation?
by Owen F. Humpage
When the Reagan administration
first
took office, it forecast federal-budget deficits of $45 billion for fiscal year (FY) 1982
and $23 billion for FY 1983, and it projected
a balanced budget by FY 1985. Fiscal year
1982, however, ended in September with a
record $110-billion deficit, and most budget
analysts now expect a deficit of approximately $170 billion to $180 billion in FY
1983. Moreover, the deficit could easily
remain above $100 billion through FY 1985
unless Congress cuts expenditures or increases taxes. The federal government must
finance these deficits by selling Treasury
securities either to the Federal Reserve System or to the public.
The prospects for large federal budget
deficits persisting over the next few fiscal
years have raised fears that the hardfought gains recently won against inflation
will be lost as the economic recovery gathers momentum. In the United States there
appears to be a long-term association between persistent budget deficits and inflation. Since FY 1960, there has been only
one year, FY 1969, when the federal
budget was not in deficit. The annual rate
of inflation, as measured
by the GNP
implicit price deflator, accelerated from a
1.0 percent to 2.0 percent range in the
early 1960s to approximately
9.0 percent
in both FY 1980 and FY 1981. The relationship between deficits and inflation,
however,
is sufficiently weak to raise
doubts about the claim that deficits cause
inflation. Between FY 1976 and FY 1979,
for example, the deficit narrowed by approximate~y $39 billion, while the rate of inflation increased by 3.0 percentage points.
This Economic Commentary explores
the possible channels through which deficits could cause inflation. Unless we can
conclusively identify channels of influence
running from deficits to inflation, we might
conclude that inflation causes deficits or

that some outside factor affects both deficits and prices simultaneously.
Equation

of Exchange

Inflation is a persistent rise in the overall
level of prices. It cannot exist without an
equally persistent
rise in the supply of
money or decline in the demand for money
that outpaces the growth of goods and
services. It is in this sense that inflation
often is described as "too many dollars
chasing too few goods."
Fisher's equation of exchange provides
a useful framework for analyzing inflation.
It is tautologically true that:
(1)

MV = PQ.

That is, the money stock (M) times the
velocity of money (V), or the rate at which
money changes hands, must equal the
price level (P) times real output
The
product of the last two terms, PQ, equals
nominal GNP. After expressing the elements of the equation in percentage rates
of change and rearranging the terms, it is
approximately true that:

«».

(2)

P%

=

M%

+

V% -

Q%.

Expressed in this manner and defined over
an appropriately
long time frame, the
equation is consistent with the earlier definition of inflation: inflation (P%) cannot
exist without an equally persistent rise in
the money supply (M%) or a decline in the
demand for money, evidenced by a rise in
velocity (V%) that outpaces the growth in
real output (Q%).
1. Throughout this article, the term money is defined narrowly as assets that function as a medium of
exchange and/or a temporary store of purchasing
power. Currency, travelers' checks, demand deposits, negotiable order of withdrawal accounts, and
time deposits are examples of assets that possess
these attributes.

Federal Reserve Bank of Cleveland
Table 1 Growth Rates for Equation of Exchange Variables
Peak to peak and trough to trough"
Velocity
growth,
percent

Money
growth,b
percent

Inflation,
percent

Period

Rate"

Differd
ence

Peak to peak
1953:IlQ-1957:lIIQ
1957:IIIQ-1960:IQ
1960:IQ-1969:lIIQ
1969:lIIQ-1973:IVQ
1973:IVQ-1980:IQ
1980:IQ-1981:IQ

2.5
1.9
2.6
5.2
7.6
10.3

-0.6
0.7
2.6
2.4
2.7

1.5
1.1
4.0
6.2
6.6
6.7

-0.4
2.9
2.2
0.4
0.1

3.1
3.7
2.8
2.6
3.7
4.2

0.6
-0.9
-0.2
1.1
0.5

2.2
3.0
4.2
3.5
2.7
0.9

0.8
1.2
-0.7
-0.8
-1.8

2.6
1.8
2.9
6.5
7.1
8.5

-0.8
1.1
3.6
0.6
1.4

1.3
1.6
4.2
6.1
6.7
8.1

0.3
2.6
1.9
0.6
1.4

3.7
3.8
3.0
2.5
4.2
0.8

0.1
-0.8
-0.5
1.7
-3.4

2.4
3.5
4.3
2.2
3.7
0.5

1.1
0.8
-2.1
1.5
-3.2

, Trough to trough
1954:I1Q-1958:IIQ
1958:1Q-1960:IVQ
1960:IVQ-1970:IQ
1970:IQ-1975:IQ
1975:IQ-1980:I1Q
1980:I1Q-1982:IQ

RateC

Differenced

Real output
growth,
percent

Rate"

Differd
ence

Rate"

Differd
ence

a. See Equation of Exchange, equation 2.
b. Money is defined as currency in circulation, demand deposits, and other checkable deposits (M-1Al
from 1960:IQ to 1982:I1Qand as currency in circulation plus demand deposits from 1953:I1Qto 1960:IQ.
c. Average annual percentage rate of growth.
d. Percentage point difference between percent rates of growth from one period to the next.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Board of Governors of
the Federal Reserve System.

more and more private-sector investment
opportunities
become unprofitable,
and
lenders become more and more cautious
about making loans. Unlike the private
sector, the government faces no interestrate constraint on its spending programs,
and Treasury debt carries essentially no
default risk. When credit is scarce, the
Treasury moves to the head of the credit
queue, squeezing some private borrowing
from the line, a phenomenon
known as
crowding out.
Most economists
acknowledge
that
crowding out occurs, but disagree about
its extent, the time frame over which it
occurs, and its importance for long-term
real growth. Many believe that in the long
run a dollar of Treasury borrowing displaces a dollar of private investment.
They argue that budget deficits are appropriate only during economic downturns
and that budget surpluses should be generated during economic recoveries so that
the budget is balanced over the business
cycle. Large deficits that persist over the

business cycle reduce the rate of private
capital accumulation;
consequently,
the
economy experiences the substitution of
slow-growth
public spending for more
rapid-growth
private spending.
Other
economists acknowledge that deficits could
result in a substitution of public spending
for private spending and allow that deficits
can influence real spending over the short
and medium term, but they contend that
deficits do not affect real economic growth
in the long term.

process and because governments
can
control their money stocks.
Over the past 30 years, changes in the
long-term rate of inflation appeared most
closely related to changes in the long-term
money-growth
rate (see table 1). When
long-term money growth accelerated (or
decelerated),
inflation nearly always accelerated (or decelerated).
Similar close
relationships in the appropriate directions
generally are not apparent when changes
in the rate of inflation are compared with
changes
in either long-term
velocity
growth or long-term real-output growth.
Changes in the long-term growth of velocity and changes in the long-term growth of
real output on occasion explain more of
the change in the rate of inflation than
changes in money-stock
growth. This is
particularly true during the most recent
periods;
however,
long-term
velocity
growth and long-term real output growth
have fluctuated within a much narrower
range than either long-term money growth
or inflation, and they frequently moved in
directions that did not contribute to the
movement in the inflation rate as shown in
equation 2. Consequently,
linkages between deficits and velocity growth and
between deficits and long-term real-output
growth are probably much less important
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland,OH
44101

for inflation than linkages between deficits
and money growth.
The monetary link between deficits and
inflation is also important, because longterm money growth is more directly under
the control of policymakers
than either
velocity or long-term real growth. Even if
persistent Treasury borrowing should raise
velocity or reduce long-term real growth,
the Federal Reserve System can undertake the necessary offsetting adjustments
to maintain price stability. In this sense,
inflation is ultimately the product of government policy. As indicated earlier, the
System's ability to conduct offsetting and
anti-inflation monetary policy is best preserved when the System is using monetaryaggregate targets instead of interest-rate
targets. For this reason the Federal Reserve's
October
1979 monetary-policy
change is an important and necessary antiinflation policy adjustment in an era when
Treasury borrowing to finance large and
persistent
federal deficits is placing upward pressure on interest rates.
Owen Humpage is an economist with the Federal
Reserve Bank of Cleveland.
The opinions stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Conclusion
This Economic Commentary has described a number of possible channels
through which large, persistent federalbudget deficits could influence the longterm growth of the money stock, velocity,
and real GNP and, hence, could cause
inflation. Of all the possibilities, the deficitinflation
linkages
operating
through
changes in the money-stock
growth rate
are particularly important because of the
unique role money plays in the inflation

Address Correction
Requested:
Please send corrected mailing label to the Federal
Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101.

November

1, 1982

Do Deficits Cause Inflation?
by Owen F. Humpage
When the Reagan administration
first
took office, it forecast federal-budget deficits of $45 billion for fiscal year (FY) 1982
and $23 billion for FY 1983, and it projected
a balanced budget by FY 1985. Fiscal year
1982, however, ended in September with a
record $110-billion deficit, and most budget
analysts now expect a deficit of approximately $170 billion to $180 billion in FY
1983. Moreover, the deficit could easily
remain above $100 billion through FY 1985
unless Congress cuts expenditures or increases taxes. The federal government must
finance these deficits by selling Treasury
securities either to the Federal Reserve System or to the public.
The prospects for large federal budget
deficits persisting over the next few fiscal
years have raised fears that the hardfought gains recently won against inflation
will be lost as the economic recovery gathers momentum. In the United States there
appears to be a long-term association between persistent budget deficits and inflation. Since FY 1960, there has been only
one year, FY 1969, when the federal
budget was not in deficit. The annual rate
of inflation, as measured
by the GNP
implicit price deflator, accelerated from a
1.0 percent to 2.0 percent range in the
early 1960s to approximately
9.0 percent
in both FY 1980 and FY 1981. The relationship between deficits and inflation,
however,
is sufficiently weak to raise
doubts about the claim that deficits cause
inflation. Between FY 1976 and FY 1979,
for example, the deficit narrowed by approximate~y $39 billion, while the rate of inflation increased by 3.0 percentage points.
This Economic Commentary explores
the possible channels through which deficits could cause inflation. Unless we can
conclusively identify channels of influence
running from deficits to inflation, we might
conclude that inflation causes deficits or

that some outside factor affects both deficits and prices simultaneously.
Equation

of Exchange

Inflation is a persistent rise in the overall
level of prices. It cannot exist without an
equally persistent
rise in the supply of
money or decline in the demand for money
that outpaces the growth of goods and
services. It is in this sense that inflation
often is described as "too many dollars
chasing too few goods."
Fisher's equation of exchange provides
a useful framework for analyzing inflation.
It is tautologically true that:
(1)

MV = PQ.

That is, the money stock (M) times the
velocity of money (V), or the rate at which
money changes hands, must equal the
price level (P) times real output
The
product of the last two terms, PQ, equals
nominal GNP. After expressing the elements of the equation in percentage rates
of change and rearranging the terms, it is
approximately true that:

«».

(2)

P%

=

M%

+

V% -

Q%.

Expressed in this manner and defined over
an appropriately
long time frame, the
equation is consistent with the earlier definition of inflation: inflation (P%) cannot
exist without an equally persistent rise in
the money supply (M%) or a decline in the
demand for money, evidenced by a rise in
velocity (V%) that outpaces the growth in
real output (Q%).
1. Throughout this article, the term money is defined narrowly as assets that function as a medium of
exchange and/or a temporary store of purchasing
power. Currency, travelers' checks, demand deposits, negotiable order of withdrawal accounts, and
time deposits are examples of assets that possess
these attributes.