DP12769 Prices and Inflation when Government Bonds are Net Wealth
In this paper I show that models in which government bonds are net wealth - that is, their value exceeds that of tax liabilities (Barro, 1974) - offer a new perspective on several issues in monetary economics. First and foremost, prices and inflation are jointly and uniquely determined by fiscal and monetary policy. In contrast to the conventional view, the long-run inflation rate here is, in the absence of output growth, and even when monetary policy operates an interest rate rule with a different inflation target, equal to the growth rate of nominal fiscal variables, which are controlled by fiscal policy. This novel theory also offers a different perspective on the fiscal and monetary transmission mechanism, policies at the zero-lower bound, U.S. inflation history, recent attempts to stimulate inflation in the Euro area and several puzzles which arise in New Keyensian models
during a liquidity trap. To derive my findings, I first use a reduced form approach in which
households derive utility from holding bonds. I prove how and for which policy rules the
price level is globally determinate, then showing that the reduced form results carry over to
a Bewley-Imrohoroglu-Huggett-Aiyagari heterogenous agent incomplete markets model.