Macro Policy and Inflation: an Overview

Inflation depends generically on current and expected monetary and fiscal policies. There are three ways to carry $1 today into the future: money, bonds, and real assets. That dollar’s purchasing power varies inversely with the price level. The real return on money depends on the flow of transactions services it supports and the expected inflation rate; the analogous return on bonds is the nominal interest rate, adjusted for risk and expected inflation; the returns on real assets are their marginal products, adjusted for risk. Arbitrages among money balances, bonds, and investment goods determine their relative values and demands. Expected money growth, tax rates, and government spending directly impinge on these expected rates of return and determine the price level and inflation rate. Given an initial tax reduction that is financed by new government debt, the paper considers alternative responses of current and future policies that are feasible, and derives the implications for inflation in several standard environments.