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Macroeconomic policy—monetary and fiscal—has two primary goals to achieve: determining the aggregate price level and stabilizing government debt. Conventional assignments give monetary policy the task of controlling inflation and fiscal policy the job of stabilizing debt. From this springs the now-standard institutional arrangements of independent central banks that target inflation, while fiscal authorities set spending and taxes to ensure fiscal sustainability.
Now research has discovered that assignments can be reversed, with monetary policy stabilizing debt and fiscal policy determining the price level. This insight has emerged by modeling fiscal behavior with the same attention to detail that monetary theory accords to monetary policy, according to Indiana University’s Eric Leeper, a pioneering scholar in this field.
Known as the fiscal theory (or, alternatively, the real theory) of the price level (FTPL), “this work builds on existing monetary and fiscal theory and in that sense it is a natural outgrowth of current thought,” Leeper writes. But, “the implications for how we treat monetary versus fiscal policy, the empirical predictions and resulting policy implications, and the intellectual framework with which we approach macroeconomic issues, are profoundly different in certain circumstances. For that reason, it is also a radical departure.”
One implication of the theory is that under some conditions, interest rates should be raised to spur inflation—not lowered, as in conventional monetary theory. Under current economic conditions, when central banks have kept rates near zero for most of a decade, consideration of how fiscal policy can be used to manage the price level is useful.
After two decades or so of research, the theoretical controversies over this idea are settled. But how do we use the fiscal theory, to understand historical episodes, data, policy, and policy regimes? Leeper, John Cochrane of the Hoover Institution, and Thomas Coleman of Chicago Harris organized this conference to address those questions and map out an ongoing research agenda.
The conference started with analysis of historical inflationary and deflationary episodes, moved on to monetary policy, and then to international issues. A common theme was various forms of price-related fiscal rules, fiscal analogues to the Taylor rule of monetary policy, which showed up in many presentations.
Several presentations focused on the gold standard as a form of fiscal commitment and examined the impact of historical episodes where nations suspended or abandoned convertibility to gold. Others analyzed various fiscal arrangements in Europe, from the Holy Roman Empire all the way up to the recent debt crises.
Christopher Sims of Princeton University addressed the issue of how policymakers could coordinate monetary and fiscal policy to achieve desired inflation. He pointed out that a key challenge is how to address the role of people’s long-term policy expectations. Another barrier to effective coordination in the US is the political economy of the legislature that sets fiscal policy institutions; in Europe, the drawback is the lack of a central fiscal authority.
Cochrane suggested areas where more research would be useful, focusing on impulse responses and discount rate variation. Harald Uhlig, playing the skeptic, challenged assembled researchers to provide “the smoking gun” for the theory. Much the way Milton Friedman and Anna Schwartz provided the evidence that solidified Irving Fisher’s MV=PY quantity theory of money, Uhlig called for the graph or data or “facts that scream FTPL” as a way to convince policymakers of the theory’s value.
—John Cochrane, Eric Leeper, and Toni Shears