Research (Economics)

Sims (2013) intended to illustrate the Fiscal Theory of the Price Level (FTPL). This comment shows that in his endeavor, Sims (2013) overlooked the fact that the FTPL does not extend to overlapping generations (OLG) or to incomplete markets

models. Otherwise he would have recognized that his simplifying assumptions are indeed knife-edge. 

Furthermore Brunnermeier et al. (2023) would not have based their misunderstanding of the workings of the FTPL in OLG and incomplete markets models on Sims (2013).

Likewise Bassetto and Sargent’s (2020) claim, that it is sufficient for fiscal policy to implicitly provide a nominal anchor through setting the real primary surplus, does not extend to OLG or incomplete markets models. To ensure determinacy, fiscal policy has to explicitly set a nominal anchor as envisaged by the seminal work of Hagedorn (2016).

According to Lorenzoni and Werning (2023), “Conflict is the most general and proximate cause of inflation”. I show that this view involves both theoretical and conceptual shortcomings. My critique is based on two main arguments.

Firstly, equilibrium conflict inflation is indeterminate, and thus does not provide a well-defined theory of inflation. The primary reason for the indeterminacy is that it is a theory based on relative prices and not on the price level.

Secondly, I argue that in almost all models, inflation is determined by monetary and/or fiscal policy. Conflict, on the other hand, plays no role in determining the steady-state inflation rate, in contrast to the claim in Lorenzoni and Werning (2023).

Similarly to the New Keynesian Phillips Curve, it merely describes a relationship between output and inflation without determining either of them.

To support my arguments, I use four standard frameworks for price-level determination:

The New Keynesian model in which monetary policy sets the nominal interest rate, a money-in-utility model in which the central bank sets the money supply, the Lagos andWright (2005) model and the Demand Theory of the Price Level (Hagedorn, 2016).

I show that state-dependent menu cost pricing models give rise to a nominal demand-augmented Phillips curve (NDPC), which adds nominal demand as a second determinant to a standard New Keynesian Phillips curves (NKPC).

According to the NDPC, inflation increases if either real marginal costs (gaps) increase [moving along the NKPC] or if nominal demand increases [shifting the NKPC].

A large increase in inflation can thus be consistent with negligible movements in the unemployment rate if the nominal demand impulse is sufficiently strong to induce a large shift of the Phillips curve. From an empirical NKPC perspective, nominal demand maps into endogenous cost-push shocks, but does not imply a non-linear Phillips curve.

I estimate the NDPC using cross-sectional data for U.S. states. Consistent with the theory, my estimates confirm that both nominal demand and marginal costs are significant determinants of inflation. 

In contrast to a large body of time series literature, the dependence of inflation on its past values is small and insignificant.

The Fiscal Theory of the Price Level (FTPL) is a promise to obtain price level determinacy even if the nominal interest rate is constant. The idea is that a unique current price level ensures that the present value government budget constraint holds.

I establish that this idea hinges on the presence of complete markets and that correspondingly, the FTPL fails to deliver on the price level determinacy promise in (dynamically efficient) overlapping generations (OLG) and incomplete market models, in which Ricardian equivalence fails. I show that the present value government budget does not determine the price level, in contrast to the FTPL logic. I also establish that the price level clears the asset market without imposing the key FTPL assumption that fiscal policy is active. 

I also explain that Kaplan, Nikolakoudis & Violate (2023) and Brunnermeier, Merkel & Sannikov (2023) do not seem to understand all aspects of determinacy, how the price level is determined in incomplete markets models or the mechanics of the Fiscal Theory of the Price Level.

This paper proposes an equilibrium theory of nominal exchange rates, which offers a new perspective on various issues in open economy macroeconomics. The nominal exchange rate and portfolio choices are jointly determined in equilibrium, thus providing a new approach to overcoming the indeterminacy results in Kareken and Wallace (1981). The distinctive features of this theory are that the nominal exchange rate is determined in international financial markets, that the risk premium and UIP deviations are fully endogenous equilibrium objects and that the real exchange rate inherits its properties from the nominal exchange rate. 

In terms of policy, this novel theory implies that a country with an exchange rate peg and free asset mobility faces a tetralemma and not a trilemma, because it loses not only monetary policy independence but also fiscal policy independence. 

In this paper, I show that heterogeneous agent incomplete markets modelsoffer a new perspective on several issues in monetary economics.  Monetary policy is assumed to work through setting nominal interest rates, while fiscal policy is committed to satisfying the present value budget constraint at all times (in contrast to the Fiscal Theory of the Price Level). 

I show that steady-state prices and inflation are jointly and uniquely determined by fiscal and monetary policy in this environment. In particular, the price level is determinatein a steady-state where the nominal interest rate is constant.

In contrast to the conventional view, the long-run inflation rate here, in the absence of output growth, and even when monetary policy operates an interest rate rule with a different inflation target, is equal to the growth rate of nominal fiscal variables, which are controlled by fiscal policy. 

The conclusion deals with some of the new perspectives that this novel theory offers,including new answers to several puzzles which arise in New Keynesian complete markets models during a liquidity trap.

This paper proposes the first methodology for assessing local determinacy in incomplete markets models. My simple determinacy criterion yields theoretical results and can be verified numerically. It merely requires calculating aggregate marginal propensities to consume (MPC) and aggregate elasticities of asset demand.

I find that the policy rules ensuring determinacy can be quite different in incomplete as opposed to complete markets models. My methodology can thus avoid the current (flawed) practice of referring to complete markets results to assess determinacy in incomplete markets models. The main findings are:

If bonds are nominal, the economy is always determinate for a constant nominal interest rate or for price level targeting if prices are sufficiently rigid. The model is indeterminate if fiscal policy is too expansionary, requiring a monetary policy response to reestablish determinacy.

If bonds are real, whether or not the Taylor principle induces determinacy depends non-linearly on MPCs, the degree of price rigidities and whether interest rates respond to output. I also find the determinacy properties of active and passive fiscal rules (Leeper, 1891) to be different in incomplete and complete markets models. I explain the shortcomings in Kaplan, Nikolakoudis and Violante (2023), which are the reason for their different and thus invalid findings.