Resolving the Fiscal Price Puzzle: General Equilibrium Effects and the Composition of Government Spending

Does government spending raise prices? While standard models predict an inflationary effect, empirical findings are mixed-a puzzle known as the "fiscal price puzzle." We argue that this puzzle reflects differences in aggregation rather than a failure of standard demand transmission. Using newly constructed U.S. MSA-level federal procurement data from 1989-2023 and a shift-share IV strategy, we show that regional fiscal shocks raise local consumer prices when aggregate forces are absorbed through time fixed effects. When aggregate conditions are allowed to respond endogenously, however, the same shocks generate attenuated or even negative price responses. To interpret these findings, we develop a two-region New Keynesian model with centralized monetary policy. Local fiscal expansions increase regional prices but induce union-wide monetary responses that dampen aggregate inflation. Extending the model to consumption and investment sectors, we show that government consumption shocks raise regional and sectoral prices more than investment shocks, yet can produce smaller aggregate price effects due to stronger monetary feedback. Our results highlight how general equilibrium mechanisms and spending composition jointly shape fiscal inflation dynamics.