DP11364 A Demand Theory of the Price Level
In this paper, I show that heterogeneous agent incomplete markets models
offer a new perspective on several issues in monetary economics.
Monetary policy is assumed to work through setting nominal interest rates, e.g. an interest rate peg or an interest rate rule, while fiscal policy is committed to satisfying the present value budget constraint at all times (in contrast to the Fiscal Theory of the Price Level).
I show that prices and inflation are jointly and uniquely determined by fiscal and monetary policy in this environment. The price level is determinate, even for a fixed nominal interest rate, while the corresponding complete markets model requires interest rate feedback rules satisfying the Taylor principle for determinacy.
In contrast to the conventional view, the long-run inflation rate here, in the absence of output growth, and even when monetary policy operates an interest rate rule with a different inflation target, is equal to the growth rate of nominal fiscal variables, which are controlled by fiscal policy.
The conclusion deals with some of the new perspectives that this novel theory offers,
including new answers to several puzzles which arise in New Keynesian complete markets models during a liquidity trap.
