Government Spending: The First & Real Factor Leading to Inflation
Understand Why and How Government Spending causes Inflation
Economists do not have a uniform and standard definition of inflation. Most economists define inflation as an increase in the general level of prices for goods and services. Austrian economists like Ludwig von Mises, on the other hand, define inflation rather as an increase in the money supply, and not necessarily a rise in prices.
According to economist Josh L. Ascough, who authored the book Inflation and Monetary Policy (2025), inflation is an excess supply of money over the demand to hold that money. Ascough’s definition is somewhat close to Mises’ definition of inflation. However, Ascough emphasized that the rise in prices does not lead to inflation but it is instead the result or consequence of it whereas Mises’ definition ignores important variables that actually lead to inflation. Thus, it then suggests, at least, that inflation takes root at the level of the money supply and not when prices start to rise.
The intention of this essay is not to dwell on the definition of inflation, but to rather understand the factors that lead to it. And there is one specific factor that triggers a chain of economic reactions that leads to inflation, and this one factor is nothing else but government spending. Hence, our inquiry here is to understand why and how government spending triggers inflation.
1. Why Does Government Spending Create Inflation?
I have written many essays on monetary policy, central banking, and especially on the Cantillon Effect. The Cantillon Effect is the redistribution of wealth through inflation. It happens when the central bank injects new money into the economy to stimulate economic growth.
What is important to understand about the whole process of the Cantillon Effect is that, first and foremost, the central bank acts as the government’s bank, even though it is supposed to be independent of political pressure. It means that when the central bank injects money into the economy, it does primarily so because the government needs money to spend on creating new programs or increasing the budget of the existing ones. Hence, the central bank injects money into the economy to first respond to the government’s financial needs. Now let us understand why government spending triggers inflation.
Government spending triggers inflation in two ways. The first way is through creating an excess demand, also known as demand-pull inflation. In this process, the government injects money into the economy to increase consumer spending by creating new programs and cutting taxes. This then creates an excess of demand for goods and services as consumers have more money to spend. It is essential to stress that the programs the government creates generate the crowding out effect, and this economic phenomenon leads to decreased private investment and makes the government a direct competitor against the private sector for resources. The government seeks to create these programs to bring the economy to full capacity. When the economy is at full capacity, then businesses can no longer easily increase production to meet this demand, which creates a discrepancy between supply and demand as demand outpaces supply. As a result, prices rise as consumers and the government compete for limited resources.
The second way is through increasing the money supply, which is also known as monetary inflation. When government spending is financed by money printing (through central banks purchasing government bonds), as is always the case to stimulate economic growth, the money supply grows. The problem is that the money supply grows faster than the economy’s ability to produce goods and services (real output), and this excess demand–due to the fact that there’s more money available to spend relative to the available goods–pushes prices up, as private businesses and the government compete for limited resources. The excess in the money supply makes the purchasing power of consumers less valuable.
Persistent government spending signals to businesses and consumers that prices will rise in the future. And as prices are anticipated to rise, workers are also expected to demand wage increases, thus creating a self-fulfilling inflationary spiral.
2. How Does Government Spending Create Inflation?
Now that we understand why government spending triggers inflation, let us now understand how it does trigger it. There are essentially three ways in which government spending leads to inflation: (1) financing through borrowing, (2) financing through money creation, and (3) fiscal stimulus in an overheated economy.
Financing Through Borrowing (Quantitative Easing)
When the government needs money to create new programs, it issues bonds to the central bank to fund its spending in exchange for liquidity. This process subsequently increases the demand for credit. As a result, interest rates will then be raised, which will crowd out private investments but still fuel demand through public projects. When the central bank buys these bonds, also known as quantitative easing, it increases the money supply which directly contributes to monetary inflation.
Financing Through Money Creation (Debt Monetization)
When the government needs to fund its deficits due to overspending, it asks for these funds from the central bank. The central bank then prints that money, which rapidly expands the money supply. This process is called “the monetization of debt.” As the central bank floods the economy with new money, it drives up prices as there is too much money chasing few goods. The issue with this process is that it leads to a devaluation of currency. Indeed, excessive money creation weakens a currency’s value on global markets, raising import costs and potentially triggering capital flight. For example, Zimbabwe’s debt monetization in the 2000s led to the collapse of the local currency, hyperinflation, and economic chaos.
Fiscal Stimulus in an Overheated Economy
Additional government spending when the economy is already at full capacity can lead to its overheating. An economy is considered overheated when it grows at an unsustainable rate, when it exceeds its capacity to produce goods and services. When fiscal stimulus is injected into an overheated economy, it leads to rising prices and potentially unstable economic conditions. For example, in 2021, U.S. stimulus packages during a recovering economy contributed to inflation hitting 7% by year-end as the supply chain struggled to keep up with demand.
3. Conclusion
It is abundantly clear that government spending is the real reason inflation occurs. The problem is that the government spends wastefully, and misallocates resources. The programs that government creates for the most part generate sub-optimal outcomes for consumers. Politicians and policymakers face incentives to prioritize short-term gains, voter appeal, or special interest groups over long-term economic efficiency. This then leads to misallocation of resources and bureaucratic inefficiency as government agencies tend to lack the flexibility and accountability of private firms.
Bureaucracies tend to overspend on low-value projects due to rigid budgets, lack of competition, or poor oversight. All these factors end up leading to waste. The private sector offers better, more efficient, and high-quality services to consumers than government does. Inflation could easily be avoided if voters did not request more government, if they did not request the “need for creating new government programs.” Government programs never really benefit its recipients, they only benefit those who legislate them.