Financial Distress and Fiscal Inflation

Is inflation 'always and everywhere a monetary phenomenon' or is it fundamentally a fiscal phenomenon? The answer hinges crucially on the underlying monetary-fiscal policy regime. Because different regimes imply completely different mechanisms for price level determination and therefore starkly different policy advice, identifying the prevailing regime is a prerequisite to understanding the macroeconomy and to making good policy choices. However, rare attention in the literature has been directed to the role of credit market frictions in discerning the policy regime, despite its growing importance in empirical macroeconomics. To fill in this gap, we augment a standard monetary model to incorporate fiscal details and credit market imperfections. These ingredients allow for both interpretations of the inflation process in a financially constrained environment. We find that introducing financial frictions to the model and adding financial variables to the dataset generate important identifying restrictions on the observed pattern between inflation and measures of financial and fiscal stress, to the extent that it overturns existing findings about which monetary-fiscal policy regime produced the U.S. data.