Study: Joint stimulus fueled inflation, hurt inclusion
Macroeconomic policy after a crisis faces a dilemma: prolonged stimulus can foster inclusive labor market recovery but risks igniting inflation. A new Bank of Canada working paper studies this trade-off after the pandemic, contrasting actual outcomes with counterfactual scenarios.
Joint stimulus amplified inflation
A quantitative model of the US economy reveals five key findings regarding post-pandemic stabilization policy.
The inflation-inclusion trade-off was unusually difficult due to the zero lower bound (ZLB) and aggregate capacity constraints.
Inflationary pressures stemmed from the joint deployment of prolonged monetary and fiscal stimulus; either policy alone would have produced milder price dynamics.
The study found that inclusive fiscal or monetary policy in isolation would have contained negative labor market hysteresis at the bottom of the distribution.
Crucially, inclusive fiscal policy combined with a more inflation-focused central bank would have achieved higher welfare for most households.
Welfare effects primarily reflect corrections of incomplete-market inefficiencies rather than aggregate stabilization gains.
The model, an extension of Alves and Violante (2025), features a three-state frictional labor market and incorporates time-varying capacity constraints that generate inflation spikes when binding, eroding real wages.
Dilemma of ZLB and capacity limits
The paper examines the inflation-inclusion trade-off in stabilization policy, a dilemma amplified by the zero lower bound (ZLB) and aggregate capacity constraints.
Inclusive recovery demands sustained monetary and fiscal support, but this prolonged stimulus risks overheating the economy and igniting inflation, eroding real wages.
The US post-pandemic recovery exemplifies this.
Both fiscal and monetary authorities pursued inclusive recovery amidst the ZLB and global supply chain disruptions.
Fiscal interventions, like stimulus checks and expanded unemployment insurance, targeted lower-income households.
Monetary policy, via the September 2020 FOMC commitment, prioritized maximum employment before rate increases, departing from its preemptive approach.
Coordination gap, welfare cost
This study provides a crucial quantitative assessment of the post-pandemic policy response, highlighting the significant welfare costs of uncoordinated monetary and fiscal stimulus.
The findings challenge the notion that an inclusive recovery necessarily requires prolonged, joint expansionary policies, suggesting a more nuanced approach could have yielded better outcomes.
For policymakers, the paper underscores the imperative of clear policy mandates and better coordination to avoid unintended inflationary consequences.