The Fallacy of the Fiscal Theory of the Price Level - Once More

March 01, 2017

Willem H. Buiter


Necessary conditions for valid general equilibrium analysis include: (1) the number of equations equals the number of unknowns; (2) if (1) holds, the resulting solution(s) make sense. The fiscal theory of the price level fails on both counts, both away from and at the ELB. The underlying fallacy is the confusion of the intertemporal budget constraint of the State with a misspecified government bond pricing equilibrium equation. This means overdetermined systems unless (a) the price level is flexible, (b) the interest rate is the monetary policy instrument and (c) there is a non-zero stock of nominal government bonds. Thus, a sticky price level or a nominal money stock rule imply inconsistency. When all three conditions are satisfied, unacceptable anomalies occur: negative price levels; the FTPL can price money when money does not exist; the logic of the FTPL applies equally to the intertemporal budget constraint of any household; when the bond pricing equation is specified correctly, there is no FTPL.

The FTPL has nothing to do with monetary vs. fiscal dominance or active v. passive fiscal policy.

The FTPL implies government debt is never a problem; the price level takes care of it, and not through unanticipated inflation or financial repression. If acted upon by fiscal authorities, the consequences could be severe.

There is a correct fiscal theory of seigniorage. The issuance of return-dominated and/or irredeemable central bank money creates fiscal space and ensures that a combined monetary-fiscal stimulus always boosts nominal aggregate demand.

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