Pawel Zabcyck and I have completed an update of our new paper on the Fiscal Theory of the Price Level. Here is the abstract of our paper. The Fiscal Theory of the Price Level (FTPL) is the claim that, in a popular class of theoretical models, the price level is sometimes determined by fiscal policy ...
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Pawel Zabcyck and I have completed an update of our new paper on the Fiscal Theory of the Price Level. Here is the abstract of our paper.
The Fiscal Theory of the Price Level (FTPL) is the claim that, in a popular class of theoretical models, the price level is sometimes determined by fiscal policy rather than monetary policy. The models where this claim has been established assume that all decisions are made by an infinitely-lived representative agent. We present an alternative, arguably more realistic model, populated by sixty-two generations of people. We calibrate our model to an income profile from U.S. data and we show that the FTPL breaks down. In our model, the price level and the real interest rate are indeterminate, even when monetary and fiscal policy are both active. Our findings challenge established views about what constitutes a good combination of fiscal and monetary policies.
Our results have profound implications for the idea that the financial markets are Pareto efficient which I explore here in my paper on asset pricing in perpetual youth models. In that paper I assume that monetary and fiscal policy are passive to generate realistic asset market volatility. My paper with Pawel shows that the same results can be generated in a realistic OLG model even when monetary and fiscal policy are active.
The way out of this apparent degeneracy of theory is to adopt an idea I first advocated in my book on self-fulfilling prophecies. The way that people form beliefs must be modeled as a new fundamental with the same methodological status as preferences, technologies and endowments.
Our paper makes a mockery of the attempt to ground neoclassical theory in ‘fundamentals’.