Question

In the past year, as inflation in the US reached 40-year highs, more than 50 million American

households have received an "inflation relief" payment from their state government in the
form of a tax refund or a check. The stated goal of these is to help residents with the higher
cost of groceries, rising energy prices and other hardships. (If needed, assume less inflation
is preferrable to more inflation). As many as 21 states approved relief payments in 2022,
with some still making payments to residents in early 2023. These policies are popular, too:
a poll last fall found 63% of Americans in favor of new stimulus checks to combat inflation.
a) Represent in normal form the game played by any two states deciding whether to enact
'inflation relief' payments or not. Describe the game and its solution (or solutions).
b) If states adopt these "inflation relief" checks and thus add to overall demand, are we all
better off or can these policies be counterproductive? Even if state policymakers
understand this, do they face an incentive to enact these policies, and does this
incentive depend on what other states are doing? Explain.

Answer 1

The goal of states providing 'inflation relief' payments can be represented using game theory, where states assess the effects of enacting or not enacting the payments. While these checks may offer short-term relief, they could contribute to further inflation by increasing aggregate demand. States may feel pressured to implement relief payments due to political reasons and the actions of other states, despite the economic consequences.

Step-by-step explanation:

The decision by states to enact 'inflation relief' payments can be represented as a game theory model where two states can either choose to enact the payments or not. In normal form, we consider the payoffs to each state based on the action it and the other state takes. This model can have multiple equilibria, depending on the payoff structure assigned to each outcome. For instance, if both states expect economic benefits from enacting the relief, they will likely do so. However, if the costs of inflation outweigh the benefits of relief checks, states may refrain from this policy.

Regarding the effect of these policies on overall welfare, it can be argued that inflation relief checks could be counterproductive by increasing aggregate demand, which could exacerbate inflation. Moreover, states may have an incentive to enact these policies, especially if other states are doing so, to prevent citizens from feeling economically disadvantaged relative to residents in other states. This incentive on inter-state comparisons and political pressures rather than strictly economic reasoning.

Discretionary fiscal policy, such as the 2020 stimulus checks, serves as an example of governments altering policies to manage economic conditions. Automatic stabilizers like unemployment insurance work to stabilize the economy by increasing aggregate demand during recessions and tempering it during booms. However, policymakers need to be cautious, as these measures can also affect inflation, which can be perceived as arbitrary and potentially unfair due to unintended redistributions of buying power.