Fiscal theory of the price level
Encyclopedia
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.
) either by:
refinancing
: rolling over the debt, issuing new debt to pay the old
amortizing: 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.
(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.
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....
affects the price level
Price level
A price level is a hypothetical measure of overall prices for some set of goods and services, in a given region during a given interval, normalized relative to some base set...
: for the price level to be stable (to control inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
), government finances must be sustainable: they must run a balanced budget
Balanced budget
A balanced budget is when there is neither a budget deficit or a budget surplus – when revenues equal expenditure – particularly by a government. More generally, it refers to when there is no deficit, but possibly a surplus...
over the course of the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
, meaning they must not run a structural deficit
Structural deficit
Structural deficit forms part of the public sector deficit. Structural deficit differs from cyclical deficit in that structural deficit exists even when the economy is at its potential....
.
It is a heterodox economic theory
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...
, in contrast to the mainstream economic theory
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
of the price level, which states that the price level is primarily or exclusively determined by the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
in the long-run
Long-run
In macroeconomics, the long run is the conceptual time period in which there are no fixed factors of production as to changing the output level by changing the capital stock or by entering or leaving an industry. The long run contrasts with the short run, in which some factors are variable and...
.
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.
Statement
In nominal terms, government must pay off its existing liabilities (government debtGovernment debt
Government debt is money owed by a central government. In the US, "government debt" may also refer to the debt of a municipal or local government...
) either by:
refinancing
Refinancing
Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic factors such as, inherent risk, projected risk, political...
: rolling over the debt, issuing new debt to pay the old
amortizing: 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
Structural deficit
Structural deficit forms part of the public sector deficit. Structural deficit differs from cyclical deficit in that structural deficit exists even when the economy is at its potential....
), 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.
History
The fiscal theory of the price level was developed primarily by Eric M. Leeper (1991), Christopher A. SimsChristopher A. Sims
Christopher Albert "Chris" Sims is an econometrician and macroeconomist. He is currently the Harold B. Helms Professor of Economics and Banking at Princeton University. Together with Thomas Sargent, he won the Nobel Memorial Prize in Economic Sciences in 2011. The award cited their "empirical...
(1994), and Woodford
Michael Woodford (economist)
Michael Dean Woodford is an American macroeconomist and monetary theorist who currently teaches at Columbia University.-Academic career:...
(1994, 1995, 2001). It has been criticized by Narayana Kocherlakota
Narayana Kocherlakota
Narayana Kocherlakota is an American economist and is the 12th and current president of the Federal Reserve Bank of Minneapolis.- Early life and education :...
and Christopher Phelan, Willem Buiter
Willem Buiter
Willem Hendrik Buiter Willem Hendrik Buiter Willem Hendrik Buiter (born September 26, 1949]] was a member of the Bank of England's Monetary Policy Committee from June 1997-May 2000. He joined the London School of Economics as a chair in the European Institute in September 2005....
(2002), Bennett T. McCallum (1999, 2001, 2003), Oscar Arce, and Dirk Niepelt.
See also
- Business cycleBusiness cycleThe term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
- Fiscal discipline
- Ricardian equivalenceRicardian equivalenceThe Ricardian equivalence proposition is an economic theory holding that consumers internalize the government's budget constraint: as a result, the timing of any tax change does not affect their change in spending...
- RubinomicsRubinomicsRubinomics, a portmanteau of Rubin and economics, was originally used to collectively describe the economic policies of President of the United States Bill Clinton. It is named after Robert E. Rubin, former United States Secretary of the Treasury....
- Structural deficitStructural deficitStructural deficit forms part of the public sector deficit. Structural deficit differs from cyclical deficit in that structural deficit exists even when the economy is at its potential....