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

1. Introduction

The fiscal theory of price level (FTPL), developed by Leeper (1991), Sims (1994) and
Woodford (1994, 1995), relates to an already well known discussion in the literature,
about whether fiscal policy plays a role, as important as monetary policy, in determining
the price level. There is also a connection to the controversy concerning the use of rules
to determine the nominal interest rate, that, as mentioned by Sargent and Wallace
(1975), leave the price level undetermined, therefore LSW argue that the government
budget constraint is crucial for the price level determination.¹

The main point behind the FTPL is indeed the idea that the price level is determined
through the inter-temporal government budget constraint. That is, the price level adjusts
in order to assure that the value of nominal government debt, divided by the price level,
equals the real present value of future budget surpluses. In other words, the price level
equals the ratio of nominal government liabilities to the present value of future budget
surpluses in real terms.

This paper adds to the literature, by offering a critical discussion of the theory and by
trying to assess the empirical evidence concerning the feasibility of the FTPL, for the
EU-15 countries, with panel data estimations, using annual data for the period 1970-
2001. To the author’s knowledge this is the first empirical attempt to globally evaluate
the relevance of the theory for that set of European countries and appears also to be, so
far, the only investigation using a panel approach to test the FTPL.

The remaining of the paper is as follows. Section two reviews the FTPL, section three
gives a critical assessment of the FTPL, section four tentatively evaluates the empirical
evidence for the EU-15, and section five is the conclusion.

¹ According to Buiter (1999) the inspiring contribution is credited to Begg and Haque (1984), even if
this is a less mentioned paper in the literature. As a matter of fact, and as Auernheimer and Contreras
(1991) mention, "An understandable reason why the Begg and Haque results are not cited in any of
the current literature is that they were published in a journal of limited audience. In fact, we became
aware of the existence of the paper by merely coincidental conversation with one of the authors."

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