The Fiscal Theory of the Price Level in a World of Low Interest Rates (with Marco Bassetto)
lead article, Journal of Economic Dynamics and Control, 2018, Special issue on ``Fiscal and Monetary Policies''.
See the discussion [paper] by Stephen Williamson
This paper asks whether the fiscal theory of the price level can uniquely determine inflation and the price level when the return on government debt is persistently below economic growth, r<g. It shows that the answer depends critically on why government bonds have low returns: risk premia can preserve price-level determinacy, whereas dynamic inefficiency or the liquidity services of public debt can generate equilibrium multiplicity.
Three principal findings
1. The source of r<g determines whether the FTPL works
Low government-bond returns caused by risk premia do not have the same implications as low returns caused by dynamic inefficiency or liquidity services. The government valuation equation remains well defined in the risk-premium case, whereas the latter environments can support multiple equilibrium price levels.
2. Persistent r<g and positive public debt generally require recurring primary deficits
When government debt pays less than economic growth but remains stable or grows relative to the economy, fiscal policy must run primary deficits on average. This is precisely the environment in which standard FTPL equilibrium selection is least robust.
3. Failure of uniqueness does not make fiscal valuation irrelevant
Even when the FTPL cannot select a unique price level, it can restrict the range of admissible prices by imposing a lower bound. But equilibrium multiplicity makes conventional comparative statics—such as predicting a unique inflationary response to lower taxes or an unfunded fiscal expansion—unreliable.
This paper is an early analysis of the FTPL in economies with r<g, public-debt liquidity services, and potential equilibrium multiplicity. Subsequent work has connected these results to theories of public-debt bubbles, incomplete markets, heterogeneous agents, and the fiscal determination of inflation.