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



Canzoneri and Diba (1996) use another terminology, already adopted by Sargent and
Wallace (1981). While the Ricardian regime is tagged as a "regime of monetary
predominance", since money demand and supply determine in this case the price level,
the non-Ricardian regime is labelled "a regime of fiscal predominance," as prices are
now endogenously determined from the government budget constraint.

In a regime where the monetary policy is independent (active), as in a Ricardian regime,
the monetary authority determines the money stock and the price level through a money
demand equation, based on the quantitative theory of money. The government is in this
case required to attain primary budget surpluses, in order that its budget constraint is
consistent with the price level resulting from the money demand equation. There is then,
according to Leeper’s (1991) terminology, a passive strategy from the Treasury and an
active behaviour from the Central Bank.

In a non-Ricardian regime, where the Treasury decides autonomously the values of the
budget deficit and of the public debt, the price level may be determined independently
from the monetary authority. In this case, the Central Bank assumes a passive attitude,
money supply is endogenous, and the price level is determined by the government
budget constraint.3 The FTPL could then be appropriate if the government did not
choose a passive fiscal policy, that is, when the budget surpluses are not adjusted
endogenously in order that the budget constraint satisfies the price level implicit in the
money demand function.

2.2. The critics from the fiscal theory to the monetarist explanation

The FTPL argues against the assumption, suggested namely by Friedman, that inflation
is purely a monetary problem. For instance, Woodford (1995) questions the idea, keen
to the quantitative theory of money, that the Central Bank should control the money
stock in order to attain price level objectives. The proponents of the FTPL maintain that
even if there is no change in money stock, fiscal policy may independently affect the
price level and the inflation rate. This situation may arise either from the possibility that

3 For instance Cochrane (2000) argues that the government budget constraint "will determine the
price level no matter what the rest of the economy looks like (...)."



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