Why deficits are sustainable and inflation has a life of its own

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My new working paper “The Fiscal Theory of the Price Level in Overlapping Generations Models” is now available here. The paper, joint with Pawel Zabczyk of the IMF, is also available as CEPR Discussion Paper 13432 and as NBER Working Paper 23445. Here is a teaser from the abstract

“We demonstrate that the Fiscal Theory of the Price Level (FTPL) cannot be used to determine the price level uniquely in the overlapping generations (OLG) model. We provide two examples of OLG models, one with 3-period lives and one with 62-period lives. Both examples are calibrated to an income profile chosen to match the life-cycle earnings process in U.S. data estimated by Guvenen et al. (2015). In both examples, there exist multiple steady-state equilibria. Our findings challenge established views about what constitutes a good combination of fiscal and monetary policies. As long as the primary deficit or the primary surplus is not too large, the fiscal authority can conduct policies that are unresponsive to endogenous changes in the level of its outstanding debt. Monetary and fiscal policy can both be active at the same time.”

Given the recent publicity for deficit spending by Olivier Blanchard writing on his PIIE blog, or the interview with Stephanie Kelton in Barrons, we think our paper is timely. We demonstrate that sensible models with realistic population demographics support some, but not all, of the arguments of Blanchard and Kelton. For example, although a large value for government debt as a fraction of GDP is not necessarily a problem, large values of the deficit probably are. In our calibrated model, (in work in progress that is not reported in the paper) we were unable to generate sustainable deficits much larger than 3% of GDP. Anything larger than that leads to an Argentinian style hyperinflation.

It also matter, a lot, who holds the debt. Large values of domestically held debt are simply a redistribution from future to current taxpayers. Large values of foreign held debt however represent a claim on the domestic economy by foreigners. Foreign held debt is much less benign than domestic debt.

Finally, our work sheds light on the current difficulty faced by western central banks who appear to be unable to hit their inflation targets. Milton Friedman argued that inflation is caused by excessive money creation. More recently, some economists have argued that inflation is a fiscal phenomenon; hence the title of this post which refers to a new theory, the Fiscal Theory of the Price Level. In contrast to both leading contenders, we show that the price level may fail to be anchored by economic fundamentals and, within certain bounds, the average price of commodities may wander aimlessly driven by the self-fulfilling beliefs of market participants.

This is the second paper of a series. The first, “The Household Fallacy” was published last year in Economics Letters. Sty tuned for further installments.