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 (to control 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.
It is a heterodox economic theory, in contrast to the mainstream economic theory of the price level, which states that the price level is primarily or exclusively determined by the money supply in the long-run.
These two contrasting views of prices may or may not contradict one another. By its proponents, the fiscal theory is seen as complementary to the quantity theory, not as replacing it; by its detractors, the fiscal theory is seen as incorrect, and either having no effect or being simply wrong-headed.
The equilibrium price level is that level that makes the real value of nominally denominated government liabilities equal to the present value of expected future government budget surpluses
— Woodford, 1995
In nominal terms, government must pay off its existing liabilities (government debt) either by:
- rolling over the debt, issuing new debt to pay the old
- paying it off from surpluses in tax revenue
...or defaulting on the debt.
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.
Thus 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 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 (meaning, on the whole, running surpluses in expansions and deficits only in contractions), is necessary for the price level to remain stable: unsustainable deficits will require inflation in future.
The fiscal theory of the price level was developed primarily by Eric M. Leeper (1991), Christopher A. Sims (1994), and Woodford (1994, 1995, 2001). It has been criticized by Narayana Kocherlakota and Christopher Phelan, Willem Buiter (2002), Bennett T. McCallum (1999, 2001, 2003), Oscar Arce, and Dirk Niepelt.
- Modern Monetary Theory
- Business cycle
- Fiscal discipline
- Ricardian equivalence
- Structural deficit
- Monetary and Fiscal Theories of the Price Level: The Irreconcilable Differences, Working Paper Series, Federal Reserve Bank of St. Louis
- This is distinct from the exorbitant privilege, which is an issue of balance of payments and foreign reserves to pay for imports, not debts.
- Explaining the Fiscal Theory of the Price Level, by Kocherlakota and Phelan of the Minneapolis Fed
- Price Level Determinacy Without Control of a Monetary Aggregate, by Michael Woodford, 1995, NBER Working Paper No. NBER_W5204
- The Fallacy of the Fiscal Theory of the Price Level, by Willem Buiter
- Leonardo Auernheimer, "Monetary Policy Rules, the Fiscal Theory of the Price Level, and (Almost) All that Jazz," in Money, Crises, and Transition: Essays in Honor of Guillermo A. Calvo. Edited by Carmen M. Reinhart, Carlos A. Végh and Andrés Velasco, Cambridge, MA: MIT Press, 2008, pp. 41-67.
In Quest of Simplicity