Scandinavian Working Papers in Economics

Seminar Papers,
Stockholm University, Institute for International Economic Studies

No 710: The Fiscal Myth of the Price Level

Dirk Niepelt ()
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Dirk Niepelt: Institute for International Economic Studies, Stockholm University, Postal: Stockholm University, S-106 69 Stockholm, Sweden

Abstract: I examine the "fiscal theory of the price level" according to which "non-Ricardian" policy and predetermined nominal government debt fiscally determine prices. I argue that the non-Ricardian policy assumption and, by implication, fiscal price level determination are inconsistent with a rational expectations equilibrium where all asset holdings reflect optimal household choices. In such a rational expectations equilibrium, policy must be Ricardian even if, in some states of nature, the government defaults or runs an exogenous real primary surplus sequence. I propose an alternative to the fiscal theory of the price level, based on nominal flows instead of nominal stocks. While this alternative framework establishes a consistent link between fiscal policy and the price level, it does not introduce inflationary fiscal effects beyond those suggested by Sargent and Wallace.

Keywords: Fiscal theory of the price level; debt issuance

JEL-codes: E31; E61

19 pages, May 16, 2002

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