Fiscal theory of the price level

The fiscal theory of the price level is the idea that government fiscal policy affects the price level: for the price level to be stable (tcontrol inflation), government finances must be sustainable: they must run a balanced budget over the course of the business cycle, meaning they must not run a structural deficit.

Statement

In nominal terms, government must pay off its existing liabilities (government debt) either by refinancing (rolling over the debt, issuing new debt to pay the old) or amortizing (paying it off from surpluses in tax revenue). In real terms, a government can also inflate away the debt: if it causes or allows high inflation, the real amount it must repay will be smaller. Alternatively, it could default on its obligations.

The fiscal theory states that if a government has an unsustainable fiscal policy, such that it will not be able to pay off its obligation in future out of tax revenue (it runs a persistent structural deficit), then it will pay them off via inflating the debt away. Thus, fiscal discipline, meaning a balanced budget over the course of the economic cycle is necessary for the price level to remain stable; unsustainable deficits will require inflation in future.

History

The fiscal theory of the price level was developed primarily by Eric M. Leeper (1991),[1] Christopher A. Sims (1994), and Michael Dean Woodford (1994, 1995, 2001).[2] It has been criticized by Narayana Kocherlakota and Christopher Phelan,[3] Willem Buiter (2002),[4] Bennett T. McCallum (1999, 2001, 2003), Oscar Arce, and Dirk Niepelt.[5]

References

  1. ^Leeper, Eric M. (1991). “Equilibria under ‘Active’ and ‘Passive’ Monetary and Fiscal Policies”. Journal of Monetary Economics. 27 (1): 129−147. doi:10.1016/0304-3932(91)90007-B.
  2. ^Woodford, Michael (1995). “Price Level Determinacy Without Control of a Monetary Aggregate” (PDF). Carnegie-Rochester Conference Series on Public Policy. 43: 1–46. doi:10.1016/0167-2231(95)90033-0. SSRN 225268.
  3. ^Kocherlakota; Phelan (1999). “Explaining the Fiscal Theory of the Price Level” (PDF). Federal Reserve Bank of Minneapolis Quarterly Review.
  4. ^Buiter, W. H. (2002). “The Fiscal Theory Of The Price Level: A Critique” (PDF). Economic Journal. 112 (481): 459–480. doi:10.1111/1468-0297.00726.
  5. ^McCallum, Bennett T.; Nelson, Edward (2005). “Monetary and Fiscal Theories of the Price Level: The Irreconcilable Differences”. Oxford Review of Economic Policy. 21 (4): 565–583. doi:10.1093/oxrep/gri032.

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