The Fiscal Theory of the Price Level

Transcription

1 The Fscal Theory of he rce Level Fernando Ballabrga Deparmen of Economcs ESADE. Unversa Ramon Llull Receved: Aprl, 2004 Absrac The Fscal Theory of he rce Level (FTL) has led o lvely academc dscusson over he las few years. Supporers clam ha he heory challenges he convenonal vew ha nflaon s always and everywhere a moneary phenomenon, and he correspondng polcy vew ha an ndependen cenral bank powerful enough o mpose he segnorage me pah s suffcen o guaranee prce sably. The heory has also been presened as provdng a poenal raonale for he mposon of fscal resrcons n moneary unons, where ncenves for fscal free-rdng are hgher han n a sngle-counry seng. Crcs, on he oher hand, clam ha he heory lacks emprcal relevance or, akng an exreme vew, ha s smply a fallacy. Ths paper brefly dscusses he man mplcaons and conroversal aspecs of he FTL, akng as a benchmark he classcal unpleasan arhmec framework of Sargen and Wallace (98). Fernando Ballabrga.<fernando.ballabrga@esade.edu> I would lke o hank J. Kröeger, W. Schuele and W. Röger for her useful commens and dscussons.

2 Governmen solvency as a sarng pon The cenral elemen n he FTL s he explc consderaon of he neremporal condon reflecng governmen solvency, along wh he dscusson as o wheher should be reaed as a consran or jus as an equlbrum condon. We sar by sang hs solvency condon. For ha purpose, le us frs wre he flow budge consran faced by he (consoldaed) governmen every perod: or B B M = R ( g τ ) (a) B B M ( R ) = ( g ) τ (b) where B s nomnal ousandng publc deb, M s base money, R s he nomnal neres rae, s he prce level, g s real governmen spendng, and τ s real ax revenue ne of ransfers. Expresson () smply says ha, each perod, he change n ousandng publc deb mus be equal o he governmen defc for he perod, whch ncludes neres paymens plus he prmary defc nclusve of segnorage revenues. By rearrangng erms, expresson () can be seen o mply ha deb dynamcs s descrbed by he followng frs order dfference equaon: B B M ( g ) r = τ where r s he real neres rae. Thus, he dscouned value of ousandng deb plus he prmary surplus of a gven perod equals he value of ousandng deb n he prevous perod. 2

3 Ths dfference equaon can be used o erae forward n he rgh hand sde of (b) n order o elmnae fuure deb erms. Afer T eraons, he expresson becomes: B M T T = δ ( τ g ) δ T (2) = 0 T B where δ s he dscoun facor appropraely defned as a funcon of fuure real neres raes. The second erm n he rgh hand sde of (2) s he presen value of fuure ousandng deb, whch wll converge o zero under he assumpon ha fuure deb ssue remans a levels domnaed by he dscoun facor 2. Thus, connung wh he sequenal elmnaon of deb erms n (2), he resulng lmng expresson s he followng: B M = δ ( τ g ) (3) = 0 Expresson (3) s he consoldaed governmen solvency condon. I saes ha, for any perod, he real value of ousandng deb mus be equal o he real dscouned value of fuure governmen surpluses. Unpleasan arhmec If seen as a resource consran ha mus be sasfed for any prce and deb levels, condon (3) ndcaes ha, a leas mplcly, a coordnaon scheme beween moneary and fscal polces s always n place. The reason s ha segnorage s a source of governmen revenue, and so s evoluon mus be compable wh he evoluon of he prmary fscal surplus n order o guaranee ha (3) holds. Therefore moneary and fscal polcy should no be analyzed n 2 Noe ha hs assumpon wll be sasfed whenever governmen deb follows a sable nonexplosve me pah. However, ever-ncreasng deb levels are no excluded as long as hey are offse by he dscoun facor. 3

4 solaon. Ths nsgh underles he unpleasan arhmec argumen of Sargen and Wallace (98), he classcal reference of a holsc approach o macroeconomc polcy analyss. Accordng o hs argumen, f defaul s ruled ou, (3) mples ha one polcy auhory mus necessarly blnk n order o guaranee governmen solvency. Ther analyss focuses on he case n whch he moneary auhory blnks. Tha s, hey proceed under he assumpon ha he polcy coordnaon scheme n place s one n whch fscal polcy moves frs, seng an exogenous pah for real spendng and axes. Moneary polcy s hen forced o merely manage he deb pah mpled by he fscal auhory choce, adjusng he pah of segnorage so as o sasfy (3). Ths polcy seng combned wh a quanave heory demand for money mples ha gh moneary polcy oday dreced a fghng curren nflaon wll evenually lead o hgher fuure nflaon, snce he moneary auhory wll be forced by condon (3) o offse he curren decrease n segnorage wh an ncrease a some pon n he fuure. Besdes, f demand for money depends on expeced nflaon, gh money oday ha sgnals loose money n he fuure wll n fac reduce curren money demand and lead o hgher curren nflaon as well. Ths unpleasan arhmec wll srongly consran he ably of moneary polcy o conrol nflaon unless he moneary auhory s able o mpose a segnorage pah ha forces he fscal auhory o blnk. Auonomous polcy behavor n he FTL A crcal dsngushng feaure of he FTL s he assumpon ha fscal and moneary polces are auonomous. Tha s, each polcy auhory ses s nsrumens accordng o s own arges and 4

5 ndependenly from each oher. In erms of smple rules, he assumpon may be formally expressed as follows: R = F π, y ) ε ( wh, F 0 F (4) 0 2 B τ g = G(, y ) wh, G 0 ν G (5) 0 2 where π s he nflaon rae, y s he oupu gap, and ε and ν are polcy shocks. Expresson (4) represens moneary polcy behavor as adjusng neres rae n response o nflaon and oupu evoluon. Expresson (5) models fscal polcy as adjusng he prmary surplus (exclusve of segnorage) n response o deb accumulaon and oupu evoluon. The exogenous non-sysemac componen of each polcy s represened by he processes ε and ν, respecvely, whch are sochascally ndependen. Therefore accordng o he polcy seng defned by (4) and (5), moneary polcy s conduced ndependenly of he evoluon of fscal varables, nvolvng no drec feedback from he governmen budge ha could force o provde segnorage n response o an evenual lack of fscal dscplne. Smlarly, fscal polcy s conduced whou any drec nfluence from moneary polcy acons. Indeed, he only possble neracons beween moneary and fscal polces embedded n hs seng are hose comng hrough general equlbrum channels 3. Solvency as an equlbrum condon raher han a consran One mporan mplcaon of auonomous polcy behavor s ha condon (3) need no be sasfed for any value of he endogenous varables B and. Thus, assume for smplcy ha here s no sablzaon polcy (F 2 = G 2 = 0 ), and suppose ha (4) s characerzed 3 For nsance, a moneary auhory ncrease n raes n response o nflaonary pressures may affec oupu and rgger a fscal reacon. 5

6 by a posve (F > 0) and srong response o nflaon and (5) by a nl reacon o deb accumulaon (G = 0). Wh such a specfcaon he prmary surplus exclusve of segnorage s exogenous, and he moneary auhory mposes a src pah for segnorage. Therefore unless B and/or adjus, here s no guaranee ha he resulng dscouned value of fuure prmary surpluses nclusve of segnorage n he rgh hand sde of (3) wll be equal o he ousandng level of real governmen deb n any gven perod. Wh B predeermned by pas decsons, he adjusmen falls 4 n. If condon (3) s only sasfed by ceran prce level pahs, becomes a condon for equlbrum and makes fscal expecaons drecly relevan for prce level deermnaon. As we argue below, n such a framework, fscal behavor may affec he prce level even wh a src pah for segnorage. Concepually, hs s n sharp conras wh Sargen and Wallace s unpleasan arhmec framework, where (3) s seen as a rue resource consran ha mus be sasfed for all admssble pahs of he endogenous varables, so a src pah for segnorage necessarly forces fscal dscplne. The fac s ha he FTL has pu forward he nerpreaon of expresson (3) no as a consran bu as a sock valuaon equaon ha deermnes he value of ousandng governmen deb as a funcon of fuure dscouned surpluses, n he same way as he fuure dscouned value of a company s dvdends deermnes he value of s ousandng sock shares. In hs nerpreaon, he governmen does no need o calbrae he pah of prmary surpluses o ensure ha s presen value budge equaon (3) holds for all admssble prce pahs, n exacly he same way as a company does no calbrae s dvdend sream o guaranee ha he presen value formula of s sock value holds for all possble values of s sock prce. In fac, n lne wh hs nerpreaon, he governmen may ssue deb a any levels lkes, 4 For exposon smplcy, we are mplcly assumng ha he real neres rae s exogenous. More realscally, f r s endogenous, he adjusmen could also come hrough he dscoun facor δ n he rgh hand sde of (3). 6

7 jus as a company can ssue equy wh no budge consran lmng he ssue operaon. In boh cases, he ssung polcy wll nerac wh prvae secor demand o clear he marke, provdng an equlbrum condon. olcy regmes When equaons (3), (4) and (5) are nsered n a general equlbrum model of he economy, several polcy regmes can be suppored as equlbrum oucomes. In FTL leraure a dsncon has been made beween sable and non-sable equlbrum, and he analyss has o a large exend been developed n a closed economy framework. Regardng sable equlbra, dscusson has focused on wo parcular cases of he polcy seng represened by (4) and (5). One case s characerzed by a vgorous an-nflaonary moneary polcy and a dscplned fscal behavor. In erms of expressons (4) and (5), we would have ha F > 0 and s large enough o nduce an ncrease n he real neres rae n response o nflaonary pressures, and G > 0 and s large enough o generae a sable pah for deb ha guaranees governmen solvency. Ths case defnes a sable moneary domnance polcy regme, where he moneary auhory ses s segnorage pah, and hen he fscal auhory reacon o deb accumulaon generaes he fscal prmary surplus pah needed o sasfy solvency condon (3) for any gven real value of ousandng governmen deb. Under hs regme, nflaon s deermned by moneary polcy acons accordng o convenonal money demand and supply mechansms. The second parcular sable case s characerzed by a weak annflaonary moneary polcy and lack of fscal dscplne. More precsely, we would have F 0, and f posve s oo small o nduce ncreases n he real neres rae n response o nflaonary pressures. In he fscal sde G 0, and f posve s oo small o generae a sable deb pah ha guaranees governmen solvency. Ths case 7

8 defnes a sable fscal domnance polcy regme. Under hs regme, none of he polcy auhores guaranee a sable pah for governmen deb, mplyng ha solvency condon (3) wll hold for any gven real level of ousandng publc deb. As a consequence, only hose pahs of B and ha adjus o guaranee ha (3) holds wll be compable wh hs regme. Ths, as we have argued, requres ha (3) be nerpreed as an equlbrum condon. Ths s he sor of fscal regme ha has been emphaszed by he FTL o suppor he argumen ha fscal facors may have effecs on he evoluon of nflaon ha are ndependen of he evoluon of segnorage. In parcular, under he fscal domnance regme jus descrbed, fscal changes (curren or expeced) wll affec he dscouned value of fuure surpluses n he rgh hand sde of (3), snce neher he moneary nor he fscal polcy programs are expeced o offse hem. Gven nhered nomnal deb, hs mples ha fscal shocks (or fuure expeced fscal acons) wll force prce adjusmens n order o mee condon (3), hus affecng he evoluon of nflaon. The economc mechansm ha accordng o he FTL underles hese prce adjusmens s he wealh effec of fscal dsurbances on prvae expendure: A ax cu, for nsance, wll reduce he dscouned sream of governmen surpluses, mplyng a hgher expeced afer-ax ncome. As a consequence, he prvae secor wll feel wealher, whch wll lead o an ncrease n he demand for goods and servces. Ths ncrease n demand wll push prces up 5. Anoher neresng dmenson of he FTL s s poenal o generae nflaonary or deflaonary sprals as non-sable (explosve) equlbrum oucomes. Ths urns ou o be he case f he moneary auhory nsss on mplemenng a vgorous an-nflaonary polcy when he fscal auhory lacks dscplne. More precsely, suppose ha F > 0 and s oo large o mply real neres rae ncreases n 5 I should be emphaszed ha Rcardan equvalence does no hold n hs framework, snce consders fscal changes ha affec he presen value of prmary surpluses. Ths s why a fscal domnance equlbrum s somemes referred o as a non-rcardan equlbrum. 8

9 response o nflaonary pressures, and G 0 and f posve, s oo small o guaranee a sable deb pah compable wh governmen solvency. Accordng o Sargen and Wallace s unpleasan arhmec framework, hs polcy regme s no feasble because none of he polcy auhores blnk : alhough he moneary auhory ses a src pah for segnorage, he fscal auhory s no forced o se a prmary surplus pah ha guaranees condon (3). Therefore he polces are seen as muually nconssen. Under he FTL framework, however, hs polcy combnaon can be suppored as an equlbrum, and so he underlyng fscal and moneary polces are poenally conssen. The resulng equlbrum does no have desrable properes, however. Specfcally, hs equlbrum s characerzed by a dynamc behavor n whch when dscouned fuure prmary surpluses are oo small (oo large) he prce level mus adjus upwards (downwards) n order o sasfy condon (3), leadng o hgher (lower) neres raes as he moneary auhory vgorously responds o nflaon (deflaon) developmens. Hgher (lower) neres raes hen lead o a hgher (lower) level of governmen nomnal lables, whch n urn lead o hgher (lower) nflaon hrough he adjusmen requred by solvency condon (3). The resul s herefore an nflaon (deflaon) spral. Ceranly, he nflaon and deflaon cases are no symmercal, snce he zero floor value for nomnal neres raes pus a sop o he process n he deflaon case. General polcy mplcaons The polcy regme axonomy descrbed above leads o wo neresng polcy conclusons. Frs, when fscal polcy behavor does no guaranee governmen solvency, he bes choce for moneary polcy s a weak an-nflaonary behavor. Ths lack of a vgorous moneary polcy wll sele he economy on a sable fscal domnance pah where fscal facors affec nflaon and moneary conrol s surrendered. However, hs s a beer choce han usng an aggressve annflaonary moneary polcy o oppose he non-dscplned fscal 9

10 behavor whch, as we have argued, would place he economy n an nflaonary/deflaonary spral. Ths possbly does n fac mply ha an ndependen cenral bank powerful enough o mpose a src segnorage me pah may no be suffcen o guaranee prce sably, n conras wh Sargen and Wallace s unpleasan arhmec framework. Second, a moneary domnance regme provdes an aracve polcy framework. Asde from he fac ha may be polcally more realsc o have moneary polcy n conrol, and echncally more feasble o fne-une moneary polcy acons, a moneary domnance regme avods he nflaonary rsk assocaed wh fscal domnance polcy sengs. olcy mplcaons for moneary unons An addonal neresng aspec of he FTL has been s applcaon o raonalze he mposon of fscal consrans o counres formng a moneary unon. The argumen goes as follows. Le us consder he unon-wde fscal solvency condon, whch saes ha he real value of he unon-wde ousandng governmen deb mus be equal o he unon-wde dscouned value of fuure prmary surpluses ncludng segnorage. Ths condon s formally dencal o condon (3), once he fscal varables are defned n erms of unon-wde aggregaes, and embeds he assumpon of unlmed lendng/borrowng acvy across unon governmens. In hs seng, accordng o he FTL, a sngle governmen lackng fscal dscplne and akng fscal acons ha reduce he value of he dscouned sream of fuure surpluses of he unon wll force an upward adjusmen of he unon prce level n order o guaranee solvency. Ths mples ha a sngle governmen may place he unon n a fscal domnance regme, pung a rsk prce sably n he whole unon. Therefore, fscal consrans ha mpose fscal dscplne across he unon are recommended, specally gven he ncenves for fscal free-rdng. 0

11 The need for he fscal dscplne ha would allow he unon o operae under a moneary domnance regme s wdely recognzed. In hs sense, he FTL mplcaons n erms of fscal consrans are no a novely. Wha s a new and poenally relevan elemen s ha hose consrans seem unavodable n he FTL framework because a srong credble moneary auhory s no suffcen per se o guaranee prce sably. A more conroversal ssue s how src hose resrcons should be, as EMU and he debae around s Sably and Growh ac (SG) have shown. The pon n hs respec s ha whle avodng fscal domnance regmes requres governmen solvency, he laer requres only a weak reacon o deb accumulaon, and s compable wh an acve sablzaon polcy. Tha s, G > 0 s needed, bu may be low n absolue value and sll be suffcen o guaranee condon (3). Besdes, we can have G 2 > 0 whou jeopardzng solvency 6. Therefore solvency can be obaned whou necessarly keepng he fscal defc below 3% and pursung a medum erm close-o-balance or n surplus poson. In hs sense, from he FTL perspecve, he SG may be seen as oo src, yng fscal hands o an exen no really requred, and so unnecessarly resrcng a poenally useful macroeconomc sablzaon ool. Crcsms The FTL has been crczed n wo man dmensons. The frs relaes o s reamen of solvency condon (3) as an equlbrum condon. The second concerns s apparen lack of emprcal relevance. Regardng he reamen of condon (3), he crcsm orgnaes n he FTL assumpon ha fscal and moneary polces are 6 All he resuls dscussed n hs paper apply when sablzaon polcy s acve, as he dervaves n expressons (4) and (5) sugges.

12 auonomous. As has already been argued, hs opens he way o nerpre he governmen solvency condon as an equlbrum condon, and no as a consran. Ths assumpon s cenral o he FTL, and s conroversal. I requres defaul for he fscal branch of he governmen (.e. segnorage revenues asde) o be ruled ou so ha consumers really see he flucuaons n he presen value of governmen prmary surplus as flucuaons n her wealh, and make correspondng adjusmens n consumpon, hus acvang he wealh mechansm ha underles he FTL argumens. Ths may be reasonable up o a ceran pon of fscal proflgacy. Bu beyond ha pon, when fscal sress creaes he percepon of governmen nsolvency, a deb-sellng mood may domnae, and he assumpon ha moneary and fscal polces are auonomous may be seen as unenable. Under pressure, he cenral bank may be expeced o jump n and provde segnorage fnancng suppor. When hs happens, we are back n he world of unpleasan monears arhmec, where one of he polcy auhores s expeced o ac n order o re-esablsh solvency. If hs s so, reang condon (3) as a rue resource consran would seem he approprae heorecal posulae. Among oher auhors, Buer (998, 999) has been srongly crcal on hs pon, concludng ha he heory s logcally flawed. Anoher weak pon conneced wh he nerpreaon of solvency condon (3) s he polcy mplcaon for moneary unons. As we have already saed, he resul depends on he resrcons mposed on he lendng/borrowng acvy across unon governmens. Under perfec rsk sharng, governmens could lend/borrow ndefnely o/from each oher. In such a case, he only relevan neremporal governmen presen value condon would be he aggregae condon for all he governmens of he moneary unon: I would no maer f any parcular governmen looked nsolven so long as anoher governmen was accumulang enough lendng resources o offse ha behavor, so aggregae solvency was guaraneed. Under hs assumpon, a sngle undscplned governmen can creae problems, and he sze of he nsolven governmen maers, snce a large 2

13 governmen wh large ousandng lables would generae more prce nsably n he fscal domnance regme han a small governmen wh a relavely small sock of publc deb. However, he assumpon of perfec rsk sharng s unrealsc because no governmen would engage n ndefnely lendng, whch would mean accepng he possbly of permanen wealh ransfers from one counry o anoher. Thus mperfec rsk sharng seems he mos approprae workng assumpon, and n parcular he assumpon ha each governmen n he unon mus guaranee s own solvency. Bu when hs dose of realsm s nroduced, FTL models mply ha even he smalles counry of he unon can n fac deermne he prce level of he whole unon. How o solve hs puzzle remans an open and mporan queson f he credbly of he FTL s o be enhanced. Wh regard o he emprcal relevance of he FTL, should frs be sad ha he emprcal dscrmnaon beween fscal and moneary domnance s no a sraghforward maer, because he long run solvency condon (3) holds n boh regmes. They are n hs sense observaonally equvalen. Ths does no mean, however, ha dscrmnaon s no possble. I only means ha he economerc denfcaon problem s more dffcul. Wh hs cavea n mnd, he avalable evdence ends o come down agans he FTL. In Boh n he US and n EU member counres, moneary domnance seems o be he prevalen regme. In parcular, he resuls for he EU sugges ha durng he perod , governmens response o deb accumulaon was generally slgh bu suffcen o guaranee solvency, hence he prevalence of a moneary domnance regme. Seleced references on he FTL The followng ls conans seleced readngs on he developmen of he Fscal Theory of he rce Level. 3

14 Theorecal papers Semnal papers Leeper, E. (99) Equlbra under Acve and assve Moneary and Fscal olces, Journal of Moneary Economcs, 27: Sargen, T.; Wallace, N. (98) Some Unpleasan Monears Arhmec, Quarerly Revew, Federal Reserve Bank of Mnneapols, Fall: -7. Sms, C. (994) A Smple Model for he Sudy of Deermnaon of he rce Level and he Ineracon of Moneary and Fscal olcy, Economc Theory, 4: Woodford, M. (994) Moneary olcy and rce Level Deermnacy n a Cash-n-Advance Economy, Economc Theory, 4: Follow-up papers Buer, W. (998) The Young erson s Gude o Neuraly, rce Level Indeermnacy, Ineres Rae egs, and Fscal Theores of he rce Level, NBER, W Seres no Buer, W. (999) The Fallacy of he Fscal Theory of he rce Level, NBER, W Seres no Cochrane, J. (998) A Frconless Vew of US Inflaon, NBER Macroeconomc Annual, 3: Cochrane, J. (200) Long Term Deb and Opmal olcy n he Fscal Theory of he rce Level, Economerca, 69: Danel, B. (2002) The Fscal Theory of rce Level n an Open Economy, Journal of Moneary Economcs, 48:

15 Leh, C.; Wren-Lews, S. (2000) Ineracons Beween Moneary and Fscal olcy, Economc Journal, 0: Woodford, M. (2000) Fscal Requremens for rce Sably. rnceon Unversy. [Mmeo] Relaed o moneary unons Bergn,. (2000) Fscal Solvency and rce Level Deermnaon n a Moneary Unon, Journal of Moneary Economcs, 45: Sms, C. (997) Fscal Foundaons of rce Sably n Open Economes. Yale Unversy. [Mmeo] Sms, C. (998) The recarous Fscal Foundaons of EMU. Yale Unversy [Mmeo]. Woodford, M. (996) Conrol of ublc Deb: A Requremen for rce Sably?, NBER, W Seres no Emprcal papers Ballabrga, F.; Marínez-Mongay, C. (2002) Has EMU Shfed olcy?, Economc aper, no. 66. European Commsson (DG ECFIN). Bohn, H. (998) The Behavor of US ublc Deb and Defcs, Quarerly Journal of Economcs, 3: Canzoner, M.; Cumby, R.; Dba, B. (2002) Is he rce Level Deermned by he Need of Fscal Solvency?, Amercan Economc Revew. Forhcomng. 5

16 Appendx: A sylzed FTL model In order o llusrae n a formal conex some of he basc FTL aspecs dscussed n he man ex, consder he followng nonsochasc IS-LM model complemened wh moneary and fscal polcy rules and wh he governmen neremporal flow budge consran (Flow BC) below: y = β ( r ) g, β > M y = (LM) R R = θπ R, θ 0 (R-Rule) B τ = α τ, α 0 (Tax-Rule) B = R B g M ( τ ) (Flow BC) The model s solved a me and all varable names concde wh hose n he man ex. The frs erm n he rgh hand sde of he (IS) represens prvae consumpon, c. As usual, he (IS) and (LM) expressons represen he equlbrum n he goods and money markes, respecvely. olcy rules (4)-(5) n he man ex are specfed here as lnear funcons, wh no reacon from polcy auhores o cyclcal flucuaons. Fnally, (Flow BC) s he governmen flow budge consran, expresson () n he man ex wren n nomnal erms. Our focal pon s fscal behavor, as descrbed by he las wo equaons of he model. As urns ou, fα > 0, so ax polcy reacs o deb accumulaon, a me pah for real governmen deb s generaed va (Flow BC) ha wll sasfy condon (3) n he man ex, and governmen solvency wll be guaraneed for any admssble pah of B 6

17 and. In hs framework, fscal dscplne wll preval and fscal polcy s sad o be Rcardan. Consumers expec fscal changes wll leave her lfe-me budge consrans unchanged, and so wll no affec aggregae demand. Thus fscal acons wll no affec prce evoluon, whch wll be fully deermned by he (R-Rule)-(IS)-(LM) block of he model accordng o he convenonal money-goods marke mechansm. In hs case, he economy s sad o operae under a moneary domnance polcy regme. On he oher hand, fα = 0, so axes are no adjused wh deb accumulaon, and here s no segnorage compensaon (no addonal creaon of base money), an explosve pah for real deb wll resul ha wll no guaranee ha he governmen solvency condon (3) s sasfed for any admssble pah of B and. Thus, per se, he (Tax- Rule)-(Flow BC) block of he model does no guaranee solvency, whch mus hen be mposed as an addonal equlbrum condon. Ths addonal condon calls for endogenous prce level adjusmens as a way o accommodae he lack of fscal dscplne, openng he channel advocaed by he FTL for fscal nfluence n prce evoluon. In hs framework, fscal polcy s ermed non-rcardan and he economy s sad o operae under a fscal domnance polcy regme. To look n greaer deal a he FTL mechansm, le us solve a parcular verson of he above model. Specfcally, assume haα = θ = 0, so fscal polcy s non-rcardan wh τ = τ, and he moneary auhory follows an R-peg polcy wh R = R. For smplcy, ake oupu and governmen spendng as consan, so y = y and g = g, and for furher algebra smplfcaon assume also ha y g =. Under hs seng, he model gves he followng soluon. The (IS) deermnes a consan real neres rae: ( r ) = β (B) 7

18 8 Gven he R-peg polcy, hs mples ha (expeced) nflaon s also consan, snce: β π = = ) ( R r and herefore, ) ( ) ( R = β π (B2) The R-peg polcy also mples, accordng o he (LM), ha money growh wll have o equal he nflaon rae n order o accommodae he consan demand for real balances gven by: R y m = (B3) Now, noe ha (B2) deermnes he nflaon rae bu no he prce level. For prce level deermnaon we urn o fscal behavor. Specfcally, snce fscal polcy s non-rcardan, he pahs for B and need o be adjused so as o guaranee governmen solvency. Tha s, hey need o guaranee condon (3) n he man ex: ) ( 0 g M B = = τ δ whch, as we have already saed, s no guaraneed by he (Tax-Rule)- (Flow BC) block under fscal domnance. In our seng, condon (3) bols down o a smple geomerc progresson. Specfcally, noe frs ha segnorage revenues (sr) are consan and gven by: ) ( ) ( R R y R y M M M sr = = = = β π Besdes, gven he consan real neres rae, he dscoun facor s:

19 δ ) = ( r = β Therefore he governmen solvency condon looks lke hs: B = β β ( τ sr g) = ( τ sr g) (B4) = 0 β Gven he exogenous fscal polcy and wh B predeermned by pas decsons, condon (B4) deermnes he prce level a me o be: β = B (B5) ( τ sr g) β Fnally, gven, he me pah for, M and B s deermned by (B2), he (LM) and he (Flow BC) respecvely, whch complees he soluon of he model. Thus n conras o a moneary domnance regme, he (R-Rule)-(IS)- (LM) block does no compleely deermne he evoluon of prces. I does deermne (expeced) nflaon, as shown n (B2), bu no he prce level, whch s deermned by fscal facors, as shown n (B5). Fscal facors herefore affec ex pos nflaon. In parcular, accordng o (B5), a ax cu ha ncreases he prmary defc wll ncrease he prce level. And he economc mechansm behnd hs prce ncrease s ndeed a wealh push n consumpon demand, as can be seen by subsung n (B4) he aggregae feasbly condon g = y c, mplc n he (IS), n order o make vsble he solvency condon for he prvae secor: β β c = ( y τ sr) β β B whch says ha he presen value of consumpon equals he presen value of fuure ne ncome plus ousandng asses. Thus a ax cu 9

20 ncreases consumpon demand by ncreasng fuure dscouned ncome. Then hgher consumpon demand pus pressure on prces, whch adjus upwards o clear he goods marke. Does he FTL model shed lgh on he Japanese experence? Japan has been sufferng from he wors recesson of all ndusralzed counres snce he Grea Depresson n he 930s. I s also he frs ndusralzed counry o experence a prolonged perod of deflaon n he pos WWII era. A he same me, s recen fscal defcs have been large, and s deb-gd rao has ncreased o a level ha has even rased concern abou susanably. How does hs square wh he predcons of he FTL? Japanese moneary polcy has been consraned by he zero bound of neres raes, and has no been able, or was no deermned enough, o expand money supply ousde he bankng sysem. Durng he perod , moneary polcy n Japan can be characerzed as an neres rae peg polcy wh 0 R. Fscal polcy has gone hrough varous changes n drecon (sop and go). Ths has led o a loss of confdence n polcy makers ably o manage he suaon. I can be argued ha fscal polcy was perceved as Rcardan ( α > 0) before 998, wh he slgh prmary defcs of 996/97 followng he large prmary surpluses of he early 90s, provdng an overall percepon of susanable publc fnances. Wh no room for moneary polcy easng, he polcy combnaon n hose years was seen as napproprae for an economy wh zero nflaon and conracng oupu. Advocaes of he FTL argued a he me ha Japan was n need of a Non-Rcardan fscal polcy n order o acvae he wealh mechansm and provde a push n prvae demand. In 998, fscal polcy shfed, wh a prmary defc/gd rao of approxmaely 7% n ha year, and wh smaller bu sll large prmary defcs n he followng years. In fac, durng he perod

21 fscal polcy could arguably be characerzed as non-rcardan ( α = 0), whch combned wh he R-peg polcy places he Japanese economy n wha seems a clear non-rcardan polcy regme smlar o he one dscussed n hs box. However, prvae demand has no been ncreasng and he economy has moved o an even more delcae suaon, wh deflaon and sagnaon domnang he scene. Does he falure of an expansonary fscal polcy o delver posve prce ncreases prove he FTL wrong? A possble explanaon s ha oher facors are offseng he effec of non-rcardan fscal expanson on demand (wealh effec). Among hese possble facors, hgher job nsecury could be mporan, wh s negave effec on dscouned expeced ncome. The large amoun of non-performng loans ha dscourage furher lendng could also be pung a brake on prvae spendng. Whou conrollng for hese oher facors, s mpossble o make a defne judgmen abou he mpac of he Japanese fscal expanson on prces. Deflaon could be worse whou. 2