Fiscal theory of the price level


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, 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.

Statement

In nominal terms, government must pay off its existing domestic liabilities either by refinancing or amortizing. 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. Alternatively, it could default on its obligations.
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, 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 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, Christopher A. Sims, and Michael Dean Woodford. It has been criticized by Narayana Kocherlakota and Christopher Phelan, Willem Buiter, Bennett T. McCallum, Oscar Arce, and Dirk Niepelt.

Citations