Disturbing the fiscal theory of the price level: Can it fit the eu-15?



interest rate set exogenously by the monetary authority, the equation of the quantitative
theory of money, equation (1), and the equation for the price level change, equation
(19), are used to determine the money stock and the price level (assuming a constant
real interest rate). However, equation (19) only determines the inflation rate and not the
price level, that is,
Pt is undetermined. In this situation, the relation of the quantitative
theory of money determines the money stock in a passive way, which adjusts to the
desired interest rate level, but it is unable to determine the price level. This
undetermination may be solved through the government budget constraint, equation (6),
that now determines the price level, the solution forwarded by the proponents of the
FTPL.8

As an alternative, if the monetary authority decides to determine the money supply,
then, in a Ricardian regime, of monetary dominance, equations (1) and (19) may
determine with no further problems the price level and the nominal interest rate. In this
case, the government budget constraint is always satisfied and will not be used to
determine the price level. Also, if the Central Bank tries to set an objective for the
money supply, when the government is carrying out an active fiscal policy, that is, a
non-Ricardian regime, the price level may be overdetermined.

Indeed, one of the results of the monetarist theory is that the use of rules to determine
the interest rate ends up in an indeterminacy for the price level, and the Central Bank
may eventually loose control of the inflation rate. In fact, in this case, money supply is
hopeless to uniquely determine the price level. The classic text is Sargent and Wallace
(1975), where it is shown that price level is indeterminate when an interest rate rule is
used and when prices are flexible. A clear exposition of this point is given namely by
Blanchard and Fischer (1989, p. 577-582), but the issue can be tracked back to Wicksell
(1965 [1898], 1907). Table 1 tries to summarise these ideas.

8 Schmitt-Grohé and Uribe (2000) and Carlstrom and Fuerst (2001) discuss the issue of nominal and
real indeterminacy in MIUF models while Bénassy (200) revisits the issue of price level
indeterminacy when there is in place an interest rate rule.

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