Fiscal mechanisms are the only way to check inflation without risking interest rates

Next, we require a policy lever for the government to mitigate inflation. In standard models, a Taylor Rule mechanism is implemented by a passive central bank. That solution is not an option in this case because MMT explicitly rules out nonzero interest rates (Mosler & Forstater, 2005) and we are interested in the case of an active government. This leaves fiscal policy as the main mechanism by which the government can affect inflation, so we model this as a lump-sum rather than distortionary tax for several reasons. First, we want to study one particular aspect of MMT in isolation and it would distract from the analysis if some results were seemingly driven by distortionary taxation. Second, we understand that in practice governments cannot have perfect foresight over the level of tax revenue collected but we model the fiscal authority as if they do. We view this as uncontroversial largely because tax authorities tend to act as if they have a certainty-equivalent level of tax revenue, otherwise budgeting would be impossible. Third, note that our model is an adaptation of the Barro-Gordon model, which collapses a dynamic choice problem into a one-shot decision when economic dynamics are ignored and the economy is in steady state from the start. Hence the same decision rule can be applied across all future periods, so there cannot be a concern about the level of tax revenue collected from lump-sum taxes changing over time. Finally, as noted above, there is significant textual evidence from MMT economists that this is exactly how policy is supposed to be done. When inflation rises, the role of the fiscal authority is to manipulate fiscal policy settings “to reduce the level of private sector demand. Labor is then transferred from the inflating private sector to the fixed wage JG sector and the BER (the ratio of JG employees to the total labor force) rises” (Mitchell et al., 2019, Ch. 19).

The imperative for fiscal action within the JG model also follows from the game theoretic hypothesis that a rational firm may in general want inflation to be lower, but will not take the necessary steps to reduce inflation themselves. If prices and wages are rising at approximately the same rate, then there is little private incentive for firms to discard their workers and hence make themselves less competitive. This introduces the need for fiscal policy to step in and take steps to slow the private sector and move workers to the JG.

Consequently, the government's policy tool for changing the inflation rate is new taxes levied on the private sector. This trade-off between inflation and taxation leads to the result that taxes reduce aggregate demand and shift workers to the JG sector, which implies that sectoral shares change following a change in taxes. Let denote the initial private sector share of the economy prior to the inflation shock and be the private sector share of the economy consistent with stable prices, both of which are exogenous. Following the MMT story, it must be that consistent with this setup, we define to be the required change in sectoral shares to return to price stability. With fiscal policy tool τ and exogenous parameter τSP that defines new taxes required for stable prices, the relationship between fiscal policy and sectoral share is given by stable prices. Following the mechanism described in the previous section, this reduction in the private sector share then reduces inflation: