Fiscal theory of the price level

What Is Fiscal Theory of the Price Level?

The Fiscal Theory of the Price Level (FTPL) is a macroeconomic theory asserting that the price level is primarily determined by government fiscal policy, specifically the real value of future government surpluses, rather than solely by monetary policy. This theory posits that the nominal value of government debt is backed by the present value of expected future primary budget deficit surpluses. In essence, if the government’s fiscal trajectory is unsustainable, the price level must adjust to equilibrate the real value of government liabilities with the expected future fiscal capacity. The FTPL falls under the broader category of macroeconomics, offering an alternative perspective on how inflation and deflation arise.

History and Origin

The foundational ideas of the Fiscal Theory of the Price Level emerged from economists' efforts to address indeterminacies in traditional monetary models, particularly when the central bank pegs the interest rate. Standard economic theory often predicted an indeterminate price level under such conditions. P²³rominent proponents like Thomas Sargent and Neil Wallace are credited with laying groundwork for the FTPL in a 1981 paper that explored scenarios where unsustainable deficits could lead to inflation unmanageable by higher interest rates. M²²ichael Woodford further developed the theory in the 1990s, particularly in his 1995 paper, presenting it as a credible alternative to the quantity theory of money. T²¹he theory gained significant attention as economists sought to understand price level determination in environments where traditional monetary policy explanations seemed insufficient.

²⁰## Key Takeaways

• The Fiscal Theory of the Price Level suggests that the aggregate price level is determined by the government's current and future fiscal decisions, including taxes and spending, rather than solely by the money supply.
• A core premise of the FTPL is that the real value of outstanding government debt must equal the present value of expected future government budget surpluses.
• If fiscal policy is "active" (meaning the government's spending and taxation plans are not adjusted to ensure debt sustainability), the price level adjusts to ensure the government's intertemporal budget constraint holds.
• The FTPL implies that even a "tough" and independent central bank may not be sufficient to guarantee price stability if fiscal policy is not appropriate.
  *¹⁹ It offers insights into periods where large debts and deficits may threaten inflation, and how financial innovation might undermine money demand.

¹⁸## Formula and Calculation

The core of the Fiscal Theory of the Price Level is encapsulated in the government's intertemporal budget constraint, often referred to as the government valuation equation. This equation states that the real value of outstanding nominal government liabilities (debt and money) must equal the present value of all expected future primary budget surpluses.

The general form of the government's present value budget constraint can be expressed as:

Where:

• (B_t) = Nominal value of total government debt at the beginning of period (t).
• (P_t) = The aggregate price level at period (t).
• (E_t) = Expectation operator conditional on information at time (t).
• (S_{t+j}) = Real primary surplus (tax revenues minus non-interest government expenditures) in period (t+j).
• (r) = Real discount rate or real interest rate.

In the context of the FTPL, if the nominal value of government debt (B_t) and the expected future real surpluses (S_{t+j}) are given, the current price level (P_t) must adjust to satisfy this equation. T¹⁷his implies that if future surpluses are expected to decline, the current price level must rise to reduce the real value of outstanding debt, thereby restoring economic equilibrium.

Interpreting the Fiscal Theory of the Price Level

Interpreting the Fiscal Theory of the Price Level (FTPL) involves understanding that the government's financial viability acts as a fundamental anchor for the price level. Unlike traditional monetarist views where the quantity of money is the primary driver of prices, the FTPL emphasizes the interaction between monetary policy and fiscal policy through the government's balance sheet.

If the public anticipates that the government will not generate sufficient future primary surpluses (e.g., through taxes or spending cuts) to cover its outstanding government debt, the real value of that debt must decrease. This decrease in real value is achieved through an increase in the price level (inflation), which erodes the purchasing power of the nominal debt. C¹⁶onversely, an expected increase in future surpluses could lead to a lower price level (deflation) as the real value of the debt needs to increase. Therefore, under the FTPL, fiscal credibility and expectations about future fiscal policy are crucial for price stability.

Hypothetical Example

Consider a hypothetical country, "Fiscopia," with outstanding government debt of $1,000 billion. Under a traditional view, if Fiscopia's central bank prints a lot of money, inflation would typically follow. However, under the Fiscal Theory of the Price Level, the dynamic is different.

Suppose the government of Fiscopia announces a significant, permanent tax cut without any corresponding reduction in public spending. This decision leads to persistently larger budget deficit and reduces the expected future primary surpluses. Investors and citizens, operating under the FTPL framework, recognize that the government's ability to repay its nominal debt through future fiscal means has diminished.

Even if the central bank holds its monetary policy constant (e.g., maintaining a stable money supply or a fixed short-term interest rate peg), the market's expectation of reduced future fiscal capacity causes an immediate adjustment in the price level. To balance the government's intertemporal budget constraint, the current price level in Fiscopia rises. This inflation reduces the real value of the $1,000 billion in outstanding nominal government debt, effectively inflating away a portion of the real debt burden to align with the lower expected future surpluses. The higher price level reflects the public's diminished confidence in the government's future fiscal rectitude, regardless of the central bank's actions.

Practical Applications

The Fiscal Theory of the Price Level offers insights into several real-world economic phenomena and policy considerations:

• Understanding Inflation in Peculiar Circumstances: The FTPL provides an explanation for inflation in situations where conventional monetary policy explanations (e.g., excessive money growth) seem insufficient. For example, if a central bank maintains a passive interest rate policy, the FTPL suggests that an active fiscal policy can still uniquely determine the price level.
  *¹⁴, ¹⁵ Policy Coordination: It highlights the critical importance of coordination between monetary and fiscal authorities. A weak fiscal stance can burden monetary policy and lead to unsustainable outcomes if policies are not aligned.
  *¹³ Government Debt Sustainability: The theory emphasizes that the sustainability of government debt is not merely a matter of current deficits but also of long-term fiscal expectations. If the public expects that debt will not be repaid through future surpluses, it will manifest as inflation.
• Impact on Zero Lower Bound (ZLB): During periods where nominal interest rate are at or near zero (the zero lower bound), the FTPL can explain why deflationary spirals might not erupt if people expect future fiscal surpluses to eventually repay the debt.

¹¹, ¹²The Federal Reserve System, the European Central Bank, and the Bank of England maintained passive interest rate policies after the 2008 global financial crisis, providing a real-world context where the FTPL's implications for price level determination became relevant.

⁹, ¹⁰## Limitations and Criticisms

Despite its contributions, the Fiscal Theory of the Price Level faces several limitations and criticisms:

One major critique is that the FTPL often relies on assumptions about infinitely-lived representative agents, which some economists argue is an unrealistic model of the economy. Studies using alternative, more realistic models (e.g., overlapping generations models) suggest that the FTPL may break down, leading to indeterminacy of the price level and real interest rate even when both monetary and fiscal policies are active.

⁸Another area of contention revolves around the distinction between the value of money and the value of government debt. Critics argue that there is no inherent reason why these values should coincide. If households anticipate a government default, they might trade government debt at a discount without necessarily affecting the value of money. S⁷ome also argue that the fiscal rules upon which the FTPL relies may be misspecified.

⁶Furthermore, the theory's "Chartalist" foundations, which posit that money is valued because the government accepts it for tax payments, make it difficult to incorporate inflation dynamics not rooted in government action, such as money creation through credit extension to the private sector by commercial banks. T⁵his can lead to potentially inaccurate diagnoses if the theory is applied without considering all relevant circumstances.

⁴Economists like Willem Buiter and Bennett McCallum have offered extensive critiques, arguing that the FTPL has "feet of clay" and that its claim to provide a universal theory of inflation is overstated, suggesting that no single theory can fully explain inflation.

², ³## Fiscal Theory of the Price Level vs. Quantity Theory of Money

The Fiscal Theory of the Price Level (FTPL) and the Quantity Theory of Money represent distinct frameworks for understanding the determination of the price level and inflation.

While the Quantity Theory of Money posits that changes in the money supply directly lead to proportional changes in the price level (assuming stable velocity and real output), the FTPL contends that fiscal conditions, particularly the public's expectations regarding the government's ability to service its debt through future surpluses, are the fundamental drivers. Confusion can arise because both theories seek to explain inflation. However, the FTPL challenges the traditional view that money supply is the sole or primary determinant, asserting that fiscal actions can dictate price dynamics, especially when monetary policy is passive or constrained.

FAQs

What does "passive" and "active" mean in the context of fiscal and monetary policy under FTPL?

In the context of the Fiscal Theory of the Price Level, "passive" and "active" describe how monetary policy and fiscal policy react to economic conditions. An "active" fiscal policy means the government sets its spending and taxation plans independently, without necessarily adjusting them to ensure debt sustainability for all possible paths of the real interest rate. Conversely, a "passive" fiscal policy implies the fiscal authority adjusts spending or taxes to ensure solvency. For monetary policy, "active" typically means the central bank raises the interest rate more than one-for-one in response to inflation, while "passive" means it raises the interest rate less than one-for-one or maintains a fixed nominal rate.

¹### Can the Fiscal Theory of the Price Level explain hyperinflation?

The Fiscal Theory of the Price Level can provide an explanation for hyperinflation. According to the theory, hyperinflation could occur if there's a significant and persistent deterioration in the public's perception of the government's future fiscal capacity (i.e., expected future primary surpluses are perceived to be very low or negative), coupled with an "active" fiscal policy that doesn't credibly commit to repaying government debt through future taxation. This loss of fiscal credibility would lead to a rapid increase in the price level to devalue the nominal debt outstanding.

How does the FTPL relate to government bond markets?

The Fiscal Theory of the Price Level directly relates to government bond markets by asserting that the real value of government bonds (a component of government debt) is determined by expectations of future fiscal surpluses. If the market anticipates that the government will not generate enough surpluses to honor its debt obligations, the real value of these bonds will decline, typically through a rise in the price level. This can affect bond yields and investor confidence in government securities, impacting public debt management.