Understanding Inflation Dynamics: The Role of Government Expenditures

This paper studies the role of government expenditure in shaping inflation dynamics via the lens of the Phillips curve. We estimate the Phillips curve implied from a structural New Keynesian model that incorporates government expenditure using aggregate US data. Our estimation results based on external instruments show that: (i) the estimated slope of the augmented Phillips curve is flatter than in the canonical specification without government expenditure; (ii) the estimated coefficient for government expenditure is significantly negative, as the theory predicts; and (iii) the variation in government expenditures is a significant component in driving inflation dynamics. The augmented Phillips curve substantially improves its ability to capture inflation dynamics, including during and after the Great Recession, as well as during the COVID-19 pandemic. Our findings provide a new perspective on understanding inflation dynamics that resolve the inflation "puzzles" in a standard framework.