Skip to main content

First Quarter 2023, 
Vol. 105, No. 1
Posted 2023-01-20

Demand-Supply Imbalance during the COVID-19 Pandemic: The Role of Fiscal Policy

by Francois de Soyres, Ana Maria Santacreu, and Henry Young


To mitigate the health and economic fallout from the COVID-19 pandemic, governments worldwide engaged in massive fiscal support programs. We show that generous fiscal support is associated with an increase in the demand for consumption goods during the pandemic, but industrial production did not adjust quickly enough to meet the sharp increase in demand. This imbalance between supply and demand across countries contributed to high inflation. Our findings suggest a sizable role for fiscal policy in affecting price stability, above and beyond what a monetary authority can do.

Fran├žois de Soyres is a principal economist in the Emerging Market Economies Section of the Federal Reserve Board; Ana Maria Santacreu is a research officer and economist at the Federal Reserve Bank of St. Louis; and Henry Young is a PhD candidate at the University of Michigan. The authors thank Ashlyn Cenicola and Jesse LaBelle for excellent research assistance, as well as Shaghil Ahmed, Matteo Iacoviello, Seung Jung Lee, Serdar Ozcan, Juan Sanchez, and Miklos Vari for useful discussions and comments.


In 1970, Milton Friedman famously said that "inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." The recent concurrence of a surge in inflation in many countries around the world and large fiscal stimulus provided in the face of the COVID-19 pandemic has renewed interest in analyzing the potential role of large fiscal spending as a driver of price increases.

There is a long line of literature about the relationship between monetary policy and fiscal policy and the unpleasant arithmetic of government debt monetization. A distinction that has become central in this particular literature is between fiscal dominance and monetary dominance. Sims, 2011 uses the fiscal theory of the price level to remind us that debt issuance is inflationary when forward-looking agents believe that newly issued government debt is only partially backed by future taxes. After a careful analysis of fiscal policy in the United States in the 1970s, he concludes that "fiscal policy can be a primary transmission mechanism or a primary source for changes in the inflation rate" (pp. 55-56). Given the large fiscal support implemented in the face of the COVID-19 pandemic, and the associated large increase in public debt, a possible shift from monetary to fiscal dominance raises the risk of more persistent inflation (Goodhart and Pradhan, 2021; Cochrane, 2021).

In this article, we bypass the role of government debt and money creation and focus directly on the association between fiscal spending and aggregate demand. We start by using cross-country data and estimating the correlation between fiscal support and various measures of economic fluctuations during the pandemic. While the successive waves of the pandemic and associated changes in mobility were the main drivers of economic activity throughout 2020 and 2021, we argue that fiscal stimulus policies might have shaped the response of consumption and production to mobility changes. Indeed, we show that countries behaved differently to lockdowns and reopenings: Countries with a larger stimulus experienced a smaller consumption decrease when mobility went down and a stronger rebound in periods of reopening. However, fiscal stimulus did not have any noticeable association with industrial production movements. By stimulating demand without boosting supply, our results suggest that fiscal support contributed to increased excess demand pressures in goods markets.

Motivated by this observation, and based on the premise that a fiscally induced imbalance between demand and supply could lead to price tensions, we then move to examine the association between exposure to fiscal stimulus, both domestic and foreign, and excess inflation, defined as inflation in excess of the country-specific pre-pandemic average. Given the delay in transmission and the continued increase in inflation from early 2021 onward and across several waves of the pandemic, we focus on a cross-sectional analysis.

Using data on trade in value added, we construct country-specific values of exposure to both domestic and foreign fiscal stimulus, where the latter is composed of two components: (i) a "vertical" component, defined as a trade-weighted average of other countries' stimulus measures, and (ii) a "horizontal" component capturing the exposure of each country's import partners to a third country's fiscal stimulus.

We find that excess inflation is significantly correlated to each country's own domestic stimulus and to various exposures of foreign stimulus. A back-of-the-envelope calculation suggests that U.S. fiscal stimulus during the pandemic contributed to an increase in inflation of about 2.6 percentage points in the U.S., 2.3 percentage points in Canada, and 0.6 percentage points in the United Kingdom.

Read the full article.