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Financial Frictions and the Fiscal Theory of Price Level Determination

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Abstract

The fiscal theory of the price level represents a significant departure from the quantity theory of money, as it implies that active (non-Ricardian) fiscal policy provides the nominal anchor and determines the price level. In this paper we take a first pass at integrating discussion of financial frictions and the fiscal theory of the price level. We first present empirical evidence in support of non-Ricardian fiscal policy, and then discuss the fiscal theory of the price level in a world with financial frictions. After illustrating how the financial friction influences the price level, we provide a theoretical explanation to our empirical findings. We also argue that the financial friction, which is related to fiscal policy, provides an additional instrument tool to the fiscal authority and an advantage over the monetary authority in choosing the equilibrium.

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Notes

  1. There is a large literature that treats (3) or (4) as a budget constraint restricting government fiscal and monetary policy, and tests (3) or (4) as a test of government solvency — see, for example, Hamilton and Flavin (1986) and Ahmed and Rogers (1995).

  2. We can certainly assume other probabilities such as, for example, ω and 1−ω. However, considering the effects of the relative number of savers (borrowers) is not pursued in this paper.

  3. This assumption could lead to a discussion similar to that in McCallum (2001). McCallum (2001) assumes a constant real public debt path and show how the price level is determined by the fiscal policy.

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Acknowledgments

This paper is based on Chapter 1 of Libo Xu’s PhD dissertation at the University of Calgary. We would like to thank Eric Leeper, Alexander Richter, Daniel Gordon, Ronald Kneebone, Gordon Sick, Jean-Francois Wen, and Lasheng Yuan for useful comments that greatly improved the paper.

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Authors and Affiliations

  1. Department of Economics, University of Calgary, Calgary, Alberta, T2N 1N4, Canada

    Libo Xu & Apostolos Serletis

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  1. Libo Xu
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  2. Apostolos Serletis
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Correspondence to Apostolos Serletis.

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Forthcoming in: Open Economies Review

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Xu, L., Serletis, A. Financial Frictions and the Fiscal Theory of Price Level Determination. Open Econ Rev 28, 251–272 (2017). https://doi.org/10.1007/s11079-016-9422-z

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