The role of fiscal policy in Britain's Great Inflation

• Published in: Economic modelling 2016-11, Vol.58, p.203-218
• Main Authors: Fan, Jingwen, Minford, Patrick, Ou, Zhirong
• Format: Article
• Language: English
• Subjects: Economic history; Economic models; Fiscal policy; Fiscal Theory of the Price Level; Identification; Indirect inference; Inflation; Performance evaluation; Price level; Price levels; Studies; Testing; UK inflation; United Kingdom
• ISSN: 0264-9993; 1873-6122
• DOI: 10.1016/j.econmod.2016.05.027

We investigate whether the Fiscal Theory of the Price Level (FTPL) can explain UK inflation in the 1970s. We confront the identification problem involved by setting up the FTPL as a structural model for the episode and pitting it against an alternative Orthodox model; the models have a reduced form that is common in form but, because each model is over-identified, numerically distinct. We use indirect inference to test which model could be generating the VECM approximation to the reduced form that we estimate on the data for the episode. Neither model is rejected, though the FTPL model substantially outperforms the Orthodox. But by far the best account of the period assumes that expectations were a probability-weighted combination of the two regimes. Fiscal policy has a substantial role in this weighted model in determining inflation. A similar model accounts for the 1980s but this role of fiscal policy is much diminished. •We test whether the FTPL model can explain the UK inflation in the 1970s.•The FTPL is equivalent to an Orthodox model in form but is numerically distinct.•The method of indirect inference suggests neither model is strongly rejected.•But the best account would suggest a weighted combination of the two.•This weighted model provides evidence of non-Ricardian fiscal policy in the 1970s.