Understanding Fiscal Theory of the Price Level

The Fiscal Theory of the Price Level is a concept that attempts to explain how government debt and taxes influence inflation. The theory suggests that the price level is determined by the government's ability to pay its debt.

In this context, the government's ability to pay its debt is crucial. According to the theory, if the government is unable to pay its debt, the price level will rise as people become less confident in the government's ability to manage the economy.

The Fiscal Theory of the Price Level was first proposed by economists Alberto Alesina and Roberto Perotti. They argued that the government's ability to pay its debt is influenced by its tax policies and spending decisions.

The Fiscal Theory of Price Level (FTPL) is a theory that explains how the price level is determined by the government's fiscal policy choices. It's based on the idea that the government's liabilities, such as debt, are valued against the expected present value of future budget surpluses.

The FTPL suggests that the price level changes when the valuation equation is violated, meaning the real value of government liabilities is not equal to the expected present value of future budget surpluses. This can happen when the government increases its spending or reduces its taxes, leading to an imbalance in the government's balance sheet identity.

According to the FTPL, the price level can adjust to restore balance through two mechanisms: asset pricing intuition and a wealth effect. If people perceive that government liabilities are not fully backed by future budget surpluses, they'll want to exchange their holdings for goods and services, increasing aggregate demand and the price level.

The wealth effect occurs when people sell bonds to buy other assets, increasing their wealth and consumption. The FTPL is compatible with other inflation theories, such as monetarism and the output gap theory, and can be used to explain how changes in expectations can trigger inflationary rebalancing.

A practical example of the FTPL in action is the Biden administration's plan to "cancel" up to $10,000 in federal student loan debt. This would reduce tax revenue and increase the net primary deficit, leading to an inflationary impact. According to estimates, student loan forgiveness could raise the price level by as much as 1.6 percent.

The FTPL is a useful tool for understanding how fiscal policy choices can influence the price level. By recognizing the importance of expectations and the government's balance sheet identity, policymakers can make more informed decisions about how to manage the economy and control inflation.

Additional reading: Difference between Total Assets and Total Liabilities

The Fiscal Theory of the Price Level (FTPL) has faced criticisms from various economists, including Marco Bassetto, who wrote about it in the New Palgrave Dictionary of Economics in 2008. The theory has been considered flawed but useful for policymakers.

Some critics, like W.H. Buiter, have argued that the FTPL is not a good theory for guiding policymakers due to its limitations. Buiter's critique was published in the Economic Journal in 2002.

Economists John H. Cochrane and Michael Woodford have also contributed to the discussion, with Cochrane publishing a book on the FTPL in 2023 and Woodford writing about price level determinacy in 1995.

For your interest: Appalled Economists

The Fiscal Theory of the Price Level has its fair share of critics. The WSJ's Greg Ip argued that solving inflation first requires solving deficits, according to a theory that advises this approach.

Marco Bassetto's 2008 work, "Fiscal Theory of the Price Level", was published in the New Palgrave Dictionary of Economics, highlighting the theory's existence.

Some critics, like Edward Chancellor, have pointed out that the theory is flawed but still useful, as mentioned in a Reuters article from April 14, 2023.

John H. Cochrane's 2023 book, "The Fiscal Theory of the Price Level", published by Princeton University Press, is a notable contribution to the theory.

However, others have questioned the theory's validity, with W. H. Buiter critiquing it in a 2002 Economic Journal article, stating it's not a viable explanation for the price level.

A 1991 Journal of Monetary Economics article by Eric M. Leeper showed that equilibria under active and passive monetary and fiscal policies can be quite different.

Several economists, including Bennett T. McCallum and Edward Nelson, have argued that the Fiscal Theory of the Price Level is irreconcilable with monetary theories of the price level, as mentioned in their 2005 Oxford Review of Economic Policy article.

The FTPL is considered a testable theory by economists, as it delivers predictions for how observed economic variables behave with respect to each other or over time.

A long body of research has theoretically and empirically demonstrated the FTPL's predictions.

However, identifying the specific policy mix is tenuous, and can require the use of external information, such as policymaker statements or dramatic changes in the economic environment.

The power of the FTPL rests in a forward-looking present-value relationship, making it challenging to test or identify the policy mix.

Current outcomes depend on expectations of the future path of fiscal revenue and expenditures, which can be assessed from an extrapolation of current policy behavior when it is rules-based.

But this is by necessity fraught with uncertainty, as the future paths of interest rates matter too, providing the discounting in the present value calculations.

Despite these empirical challenges, the FTPL provides a framework for assessing surprise fiscal policy actions.

Explore further: Present Value of Growth Opportunities

Fiscal policy and monetary policy interact in complex ways, as described by the Fiscal Theory of the Price Level (FTPL). Monetary policy plays a crucial role in controlling inflation, but its success depends on the institutional setting of a country and the resulting fiscal policy stance.

Monetary policy can guide inflation expectations by targeting interest rates, but fiscal policy is responsible for unexpected inflation. The FTPL distinguishes between active and passive states of fiscal and monetary policy, with passive fiscal policy adjusting revenue and expenditure to maintain the government valuation equation.

In a passive fiscal policy setting, monetary policy can keep inflation low without inflation surprises induced by fiscal policy. However, with active fiscal policy, monetary policy becomes passive, and the central bank needs to generate seigniorage revenue by printing money to keep the government solvent.

Explore further: Active Labour Market Policies

The FTPL has a unique relationship with monetary policy, particularly when it comes to interest rates. In the FTPL, interest rate hikes increase inflation, which is counterintuitive to the conventional view that higher interest rates decrease inflation.

The model's intuition is straightforward: higher interest rates increase the government's refinancing costs, making it harder for the government to repay its debt, and leading to increased inflation.

Curious to learn more? Check out: Buckland V Bournemouth University Higher Education Corp

The FTPL assumes that households have rational expectations, meaning they're perfectly informed and knowledgeable about how interest rate changes will affect future surpluses. This leads to a situation where interest rate increases can cause a temporary decline in inflation, but ultimately lead to higher inflation in the future.

Monetary policy, in the form of interest rate targets, can fully control expected inflation in the FTPL, but fiscal policy fills in the gap, determining unexpected inflation and thus fully determining inflation. This is a key point in the FTPL, and one that sets it apart from conventional monetary policy views.

Monetary policy plays a crucial role in controlling inflation, and its success depends on the institutional setting of a country and the resulting fiscal policy stance.

According to the FTPL, monetary policy can guide inflation expectations by targeting interest rates, which can be effective when the public holds rational expectations.

A unique perspective: Draftkings Earnings Expectations

In a passive fiscal policy setting, the government adjusts revenue and expenditure to maintain the government valuation equation, allowing an independent central bank to keep inflation low without inflation surprises induced by fiscal policy.

With active fiscal policy, however, monetary policy no longer controls inflation, and the central bank needs to generate seigniorage revenue by printing money to keep the government solvent.

The FTPL distinguishes between active and passive states of fiscal and monetary policy, with passive monetary policy pursuing other goals, such as government solvency or full employment.

Here's a summary of the active and passive states of fiscal and monetary policy:

In a passive monetary policy setting, the central bank may give up the monetary reins, leading to inflationary pressures and potentially even hyperinflation episodes.

The Fiscal Theory of the Price Level (FTPL) has some surprising predictions about interest rates and inflation. According to the FTPL, higher interest rates actually increase inflation, not decrease it.

The model's intuition is straightforward: higher interest rates increase the government's refinancing costs, making debtors less confident in the government's ability to repay its debt. This leads to a decrease in the expected future budget surpluses, causing the public to sell bonds and money holdings to buy goods, thereby increasing inflation.

The model assumes that households have rational expectations, meaning they perfectly understand how interest rate changes will affect future surpluses and act accordingly. However, this assumption seems like a big stretch, as it's hard to imagine households being so perfectly informed.

The FTPL's prediction that higher interest rates increase inflation is counter-intuitive, as conventional wisdom assumes the opposite. However, the model's author, John Cochrane, notes that this prediction only holds under certain conditions, such as sticky prices and large amounts of long-term domestic-currency debt outstanding.

Monetary policy, which chooses interest rates without changing fiscal policy, can fully control expected inflation in this simple model. Fiscal policy fills in the gap, determining unexpected inflation and thus fully determining inflation.

A unique perspective: Expected Loss

In conclusion, the fiscal theory of the price level suggests that fiscal policy has a significant impact on the price level, particularly in the long run. Fiscal policy can influence the price level by affecting the level of aggregate demand.

The Fisher equation, which states that the price level is equal to the expected future price level plus the expected future interest rate, is a key component of the fiscal theory of the price level. This equation shows that the price level is not solely determined by monetary policy, but also by fiscal policy.

Fiscal policy can also influence the price level by affecting the level of government debt, as discussed in the article. An increase in government debt can lead to an increase in the price level, as the government must issue more bonds to finance its spending.

The empirical evidence presented in the article suggests that the fiscal theory of the price level is a useful framework for understanding the relationship between fiscal policy and the price level. The results of the study showed that fiscal policy has a significant impact on the price level, particularly in the long run.

In the long run, the price level is determined by the level of aggregate demand, which is influenced by fiscal policy. This means that fiscal policy can have a significant impact on the price level, particularly if it is used to finance large government spending programs.

If this caught your attention, see: Capital Spending Equation