DP11975 The Good and the Bad Fiscal Theory of the Price Level

Author(s): Willem H. Buiter
Publication Date: April 2017
Keyword(s): Fiscal theory of the price level; intertemporal budget constraint; equilibrium bond pricing equation; monetary and fiscal policy coordination
JEL(s): E31, E40, E50, E58, E62, H62, H63
Programme Areas: Public Economics, Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11975

Necessary conditions for valid dynamic general equilibrium analysis include: (1) the number of equations equals the number of unknowns; (2) the number of state variables equals the number of boundary conditions; (3), if (1) and (2) hold, the model has one or more solutions and these solutions make economic sense. The fiscal theory of the price level – in any of its variants - fails these conditions, both away from and at the effective lower bound. The fundamental fallacy at the root of the FTPL is not requiring the intertemporal budget constraint (IBC) of the State to hold identically but only in equilibrium, and treating the IBC of the State (holding with equality and with sovereign debt priced at its contractual value) as a (misspecified) government bond pricing equilibrium condition. Arbitrary (non-Ricardian) policies governing public spending, taxation, interest rates and monetary issuance are asserted to satisfy the intertemporal budget constraint of the State in equilibrium because either the price level (in the original FTPL) or the level of real economic activity (in the Keynesian version of the FTPL developed by Sims) will adjust to make the real contractual value of the outstanding stock of nominal public debt equal to the present discounted value of current and future primary surpluses plus seigniorage. In reality this means overdetermined or inconsistent systems unless (a) the price level is flexible, (b) the interest rate is the monetary policy instrument and (c) there is a non-zero stock of nominal government bonds. Thus, a sticky price level implies overdeterminacy or another inconsistency, and a nominal money stock rule implies overdeterminacy. When all three conditions are satisfied, unacceptable anomalies occur: the possibility of negative price levels; the FTPL can price money when money does not exist; the logic of the FTPL applies equally to the intertemporal budget constraint of an individual household; when the bond pricing equation is specified correctly, there is no FTPL. The FTPL has nothing to do with monetary vs. fiscal dominance or active v. passive fiscal policy. The FTPL implies government debt is never a problem; the price level or the level of real economic activity take care of it, and not through unanticipated inflation or financial repression. If acted upon by fiscal authorities, the consequences could be severe. There is a correct fiscal theory of seigniorage. The issuance of return-dominated and/or irredeemable central bank money creates fiscal space and ensures that a combined monetary-fiscal stimulus always boosts nominal aggregate demand.