Big Government Means More Inflation — Not

Conventional wisdom holds that inflation rises with government spending: greater demand pushes prices up, and the state prints more money to keep up. For proponents of small government, such as Ron Paul, the insidiousness of the “inflation tax” is a rallying cry for peeling back government spending. (And, in Paul’s case, implementing the gold standard.)

Source: St. Louis Fed

But does the magnitude of inflation depend on what the government is spending money on?

A study published recently by the Federal Reserve Bank of St. Louis says it does. Contrary to conventional wisdom, a comparison of 80 countries by economists Song Han of the Federal Reserve Board staff in Washington and Casey B. Mulligan of the University of Chicago found a significant negative correlation between nondefense government spending and inflation. That is, as countries spend more on nonmilitary expenditures, inflation tends to decrease.

On the other hand, Han and Mulligan report a strong positive relationship between inflation and government size in times of war. Wars tend to lead to sudden booms in government spending. Using U.S. and U.K. data from as long ago as the 18th century, the authors found inflation rising as wars began and falling as they ended. The only exception was the aftermath of Vietnam War –one of the few American wars, the authors note, that didn’t end in an unambiguous victory for the United States. “Inflation responds strongly,” they write, “to the nature of how a war ends.” –Anton Troianovski