High government spending means more inflation? It’s complicated, say economists
OTTAWA — Conservative leader Pierre Poilièvre’s attempt to block the federal government’s budget bill earlier this month is the latest example of government spending coming under scrutiny amid high inflation.
And while most fiscal experts agree that government spending can fuel inflation, economic research suggests the link between the two is more complex.
The leader of the opposition demanded that the federal government present a plan to balance its budget or his caucus would filibuster the bill. He argued that by running deficits, the government was driving up inflation and forcing the Bank of Canada to keep interest rates high.
His demands were ultimately not met and the budget bill was passed in the House of Commons.
But government spending scrutiny is far from over as inflation remains high and the Bank of Canada risks raising interest rates again after raising its key rate to 4.75 percent earlier this month.
At the same time, economists say government spending can affect both demand and supply in the economy, making the overall impact on inflation harder to read.
Stephen Williamson, an economics professor at Western University, said the idea that more government spending equals more inflation is “something you could teach, like a sophomore (university) class.”
“It’s more complicated,” he said.
There are competing theories on the matter, he says, with mixed findings in the economics literature.
Take, for example, a new study from the Bank of Canada that looks at US data on inflation and government spending. It found that an increase in government spending can actually reduce inflation.
The study, published earlier this month, by Yinxi Xie of the central bank and Chang Liu of the National University of Singapore, focuses specifically on government spending on goods and services, excluding transfer payments to people and businesses.
“Our results run counter to the conventional wisdom that fiscal expansions are inflationary,” the authors wrote.
“We find that inflation is falling due to an increase in government spending and that the effect is relatively persistent, lasting about a year and a half.”
The researchers suggest that an increase in government spending may reduce inflation by boosting employment, increasing supply in the economy.
Trevor Tombe, an economics professor at the University of Calgary, said that under this theory, people choose to work more when government spending rises because they expect taxes to rise as well.
“This is presented as somewhat counterintuitive results, that an increase in government spending can lower inflation,” Tombe said.
However, Tombe cautioned against drawing definitive conclusions from one study finding.
“Sure, it’s interesting. That is a valuable contribution. But no document is the end of the conversation,” he said.
Williamson agreed, noting that the paper does not look at government transfers, such as those sent during the COVID-19 pandemic.
But the idea that government policy can reduce inflation by reducing supply is not new.
Stephen Poloz, former governor of the Bank of Canada, has argued that the federal budget, which focused heavily on green economy growth, could actually help reduce inflation by increasing the economy’s productive capacity.
And Treasury Secretary Chrystia Freeland was quick to quote Poloz in defense of her spending plans.
As for what caused Canada’s current period of high inflation and what role government spending played, Tombe said that’s still an open question.
“We’ll be studying this period for decades to come,” Tombe said.
This report from The Canadian Press was first published on June 19, 2023.
