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



2. The fiscal theory of the price level set-up

Underlying the work developed by LSW is the idea that for some combinations of fiscal
and monetary policy, the price level is determined by the ratio between government
nominal liabilities and the real present value of future government assets (budget
surpluses). This is an important issue since central banks seem to be now less
enthusiastic in using monetary rules for their monetary policy decisions. The
implementation of such rules is usually regarded as an attempt to capture the visible
historical relationship between money and prices.

Several presentations and critical discussions of the theory and of its assumptions are
offered namely by McCallum (1999a, 1999b, 2001), Buiter (1998, 1999, 2001) and
Bassetto (2001), while explanations of the theory can be found in Kocherlakota and
Phelan (1999), Christiano and Fitzgerald (2000) and Carlstrom and Fuerst (2000).
Concerning the empirical testing of the theory, the literature is rather small, but one can
mention the papers of Canzoneri, Cumby and Diba (1997, 2000), Cochrane (1999) and
Woodford (1999), Mélitz (2000) and Creel and Sterdyniak (2000). 2

2.1. Ricardian versus non-Ricardian regimes

The set-up for the FTPL may be understood on the basis of the categorization of two
types of fiscal regimes, the way is done for instance by Woodford (1995): Ricardian
versus non-Ricardian regimes. Actually, this classification had already been used by
Aiyagari and Gertler (1985) who maintained that in a non-Ricardian regime the
Treasury does not commit itself to match completely, in the future, new public debt
with future taxes, since some part of the new debt is to be financed through money, the
opposite of what would happen in a Ricardian regime.

2 The literature on the FTPL has increased substantially, rendering difficult an exercise of keeping up
with all the incoming references on the topic. Nevertheless, one can mention additionally papers by
Woodford (1996, 1998a, 1998b, 2001), Cochrane (1999, 2000, 2001) and Sims (1999). The use of
the FTPL in an international framework is discussed by Woodford (1996), Sims (1997, 1999), Dupor
(2000), Bergin (2000), Canzoneri, Cumby and Diba (2001), Andrés, Ballabriga and Vallés (2000)
and Daniel (2001). Loyo (2000) addresses the inflationary episodes in Brazil using the FTPL while
Sims (2001) makes a similar attempt to assess the consequences of dollarization in Mexico. Also in
the context of the FTPL, Corsetti and Mackowiak (2000) discuss and relate the occurrence of
currency devaluations to the existence of fiscal unbalances.



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