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

Table 1 - Fiscal determination of price level and monetary policy

(*) The case mentioned by Sargent and Wallace (1975).

(**) Leeper (1991), Sims (1994) and Woodford (1994,1995).

Buiter (1998, 1999, 2001), one of the critics of the FTPL, argues that the theory
proposed by the work of LSW is what he calls “the pure fiscal theory of the initial price
level” (Buiter [1998, pp. 25]). In fact, Buiter (1998) mentions that the initial price level
is determined by equation (25) and is proportional to the stock of non-monetary
liabilities (public debt), and this could be understood strictly as what the author
mentions as the “quantity theory of nominal bonds.” However, and taking into account
the initial price level, in the following periods prices will be determined by equation
(19). Besides, the nominal stock of money has an effect on the nominal interest rate,
that is, for a given level of public debt and prices, an increase of the money stock
implies a decrease of the nominal interest rate and, with a constant real interest rate,
there should be a decrease of the future nominal value of government debt. The decline
of public debt will then lower the price level, and so Buiter maintains that money still
influences prices.

Buiter stresses also the fact that it does not seem reasonable that the government uses
the budget constraint (6) to determine the primary balance and the issuance of public
debt, without taking into account a given price level. Also, the models presented by the
proponents of the FTPL, give the impression that they are determining a level of public
debt default and not so much the price level. If the responsibles of economic policy
were to adopt the ideas of the FTPL, there would end up to appear either situations of
default on public debt reimbursements or situations of hyperinflation.

Cochrane (2000) answers back to Buiter’s criticisms by saying that Buiter is taking for
granted a Walrasian formation of prices in the market, were no transaction occurs until

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