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How government spending can affect inflation

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Sen. Joe Manchin gets into a car near the Capitol building.

Sen. Joe Manchin, a West Virginia Democrat, said Thursday that he had agreed to support the Biden administration's climate change package. Anna Moneymaker via Getty Images

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President Joe Biden’s Build Back Better proposal appears to be stalled on the opposition of Sen. Joe Manchin, who says the federal spending would lead to more inflation. Goldman Sachs is predicting weaker economic growth next year with the apparent failure of the bill. 

Now, it’s anybody’s guess what will happen with the legislation or if it even has a path forward. 

But just how much of the 6.8% annual inflation rate we’ve been talking about is related to government spending?

Economics professors sometimes teach about inflation using the visual of a bathtub: If money pours into the economy faster than it can drain, it will spill over. 

But Leah Downey at the Sheffield Political Economy Research Institute in England prefers a flower bed analogy. 

“If you pour a lot of water on the bits that are already saturated, it’s going to overflow,” she said.

Downey argues that high spending does not necessarily lead to inflation. “It depends on how you spend and what you spend on and when you spend.”

Programs like early childhood education might cost a lot upfront but are designed to reap benefits down the road, she added.

Bill Dupor with the Federal Reserve Bank of St. Louis researched government spending from the 1960s to 2005.

“So when government spending increases rapidly, for example, for defense spending, we don’t see inflation go up by very much at all,” he said.

That’s true for other government programs too. But short-term spending is different, according to Chris Sims, professor emeritus at Princeton.

Take those relief checks meant to keep people afloat and prevent a deep recession. “And it succeeded in that. We’re getting a little bit of an overshoot,” Sims said.

That increase in consumer demand affected supply, which affected prices. Low-income families tend to spend more on necessities that are pricier now, like groceries, heat and gas, said Wharton School professor Kent Smetters.

“And so more fiscal stimulus that targets lower-income households will tend to have more impact on inflation going forward,” Smetter said.

But he also pointed out that supply chain constraints and labor shortages are contributing too. 

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