Discussion paper

DP2205 The Fallacy of the Fiscal Theory of the Price Level

It is not common for an entire scholarly literature to be based on a fallacy, that is, "on
faulty reasoning; misleading or unsound argument". The 'fiscal theory of the price
level', recently re-developed by Woodford, Cochrane, Sims and others, is an example
of a fatally flawed research programme.
The source of the fallacy is an economic misspecification. The proponents of the
fiscal theory of the price level do not accept the fundamental proposition that the
government's intertemporal budget constraint is a constraint on the government's
instruments that must be satisfied for all admissible values of the economy-wide
endogenous variables. Instead they require it to be satisfied only in equilibrium.
This economic misspecification has implications for the mathematical or logical
properties of the equilibria supported by models purporting to demonstrate the
properties of the fiscal approach. These include: overdetermined (internally
inconsistent) equilibria; anomalies like the apparent ability to price things that do not
exist; the need for arbitrary restrictions on the exogenous and predetermined variables
in the government's budget constraint; and anomalous behaviour of the 'equilibrium'
price sequences, including behaviour that will ultimately violate physical resource
constraints.
The issue is of more than academic interest. Policy conclusions could be drawn from
the fiscal theory of the price level that would be harmful if they influenced the actual
behaviour of the fiscal and monetary authorities. The fiscal theory of the price level
implies that a government could exogenously fix its real spending, revenue and
seigniorage plans, and that the general price level would adjust the real value of its
contractual nominal debt obligations so as to ensure government solvency. When
reality dawns, the result could be painful fiscal tightening, government default or
unplanned recourse to the inflation tax.

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Citation

Buiter, W (1999), ‘DP2205 The Fallacy of the Fiscal Theory of the Price Level‘, CEPR Discussion Paper No. 2205. CEPR Press, Paris & London. https://cepr.org/publications/dp2205