Adam Ozimek asks about inflation, for his bartender

A question for econtwitter from my bartender. If the US government via deficit spending engages in economic development in other countries, does that increase inflation here?

I would approach this question as follows.  Assume the government is running a foreign aid program that mostly makes purchases and investments abroad with non-U.S. suppliers, furthermore assume floating exchange rates.

The foreign aid, a kind of capital outflow, will induce the dollar to depreciate somewhat, a’ la “the transfer problem” of the 1920s.  That will lead to a modest inflationary impact on imported goods, possibly of a one-off nature if the foreign aid is itself a one-off policy.  American exporters will gain, noting that under some unusual assumptions about the terms of trade the U.S. domestic economy can end up better off.  (Induced profits on the depreciation can in principle outweigh the initial loss from the transfer, though please “do not try this at home.”)

If the deficit is monetized, the exchange rate may depreciate all the more, as individuals shift their future expectations toward a more expansionary monetary policy.  Furthermore, the higher global money supply of dollars would give foreigners a higher option value on making purchases in the United States, another form of (likely modest) inflationary pressure.

If the deficit is financed by borrowing, someday that debt must be repaid.  If it is repaid by higher taxes, that has a deflationary effect on aggregate demand, though the incentive effects of the taxes will lower supply in the future, again creating a (probably modest) upward push on the price level as a further effect.

If you wish, you can toss in added second- and third-order effects on those taxes on exchange rates, terms of trade, and so on.

As an exercise to be performed at home, what if the U.S. sends aid to a dollarized economy, such as Ecuador or El Salvador?


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