Monetary-ﬁscal policy interactions and the price level: Background and beyond
Eric M. Leeper · Tack Yun
Springer Science + Business Media, LLC 2006
Abstract The paper presents the ﬁscal theory of the price level in a variety of models, including endowment economies with lump-sum taxes and production economies withproportional income taxes. We offer a microeconomic perspective on the ﬁscal theory by computing a Slutsky-Hicks decomposition of the effects of tax changes into substitution, wealth, and revaluation effects. Revaluation effects arise whenever tax changes alter the value of outstanding nominal government liabilities by changing the price level. Under certain assumptions on monetary and ﬁscalbehavior, the revaluation effect reﬂects the ﬁscal theory mechanism. When taxes distort, two Laffer curves arise, implying that a tax increase can lower or raise the price level and the revaluation effect can be positive or negative, depending on which side of a particular Laffer curve the economy resides. Keywords Income taxes . Inﬂation . Debt revaluation . Laffer curve Jel Code: E31 . E52 . E62 1.Introduction Occasionally a new idea in macroeconomics generates professional reactions that are, in equal parts, excitement and vitriol. The ﬁscal theory of the price level is such an
E. M. Leeper ( ) Department of Economics and Center for Applied Economics and Policy Research, Indiana University and NBER e-mail: firstname.lastname@example.org T. Yun Monetary Affairs Division, Federal Reserve Board e-mail:Tack.Yun@frb.gov
E. M. Leeper, T. Yun
idea. It is provocative because it attributes to ﬁscal policy a potentially important role in determining the general level of prices in the economy, placing it in direct competition with the venerable quantity theory of money. At the same time, the ﬁscal theory constitutes a new channel for breaking Ricardian equivalence—one thatcomes from the valuation of nominal government liabilities. Unlike existing methods for deviating from Ricardian equivalence, which rely on market imperfections, myopic consumers, or tax distortions, the ﬁscal theory arises from particular combinations of monetary and ﬁscal policies. The label “the ﬁscal theory of the price level” would seem to imply that ﬁscal policy alone determines the pricelevel, and this is certainly the tone of several papers on the topic. We regard the label to be a misnomer. In all theories of price level determination—whether the ﬁscal theory or the quantity theory—the equilibrium price level emerges from particular combinations of monetary and ﬁscal policy behavior. In both theories it is impossible to even derive an equilibrium without completely specifying bothmonetary and ﬁscal behavior. Where the theories part company is in their predictions of how monetary or ﬁscal changes affect the price level. The ﬁscal theory lurks in any dynamic model with monetary and ﬁscal policies. The theory’s linchpin is a ubiquitous dynamic equilibrium condition that equates the real value of total nominal government liabilities—typically high-powered money plus unindexeddebt—to the expected discounted present value of net-of-interest surpluses plus seigniorage.1 This condition stems from combining the government’s intertemporal budget constraint with some private-sector optimality conditions. Critiques of the ﬁscal theory spring, in large part, from interpretations of the role this condition plays in determining equilibrium. This paper tries to avoid thecontroversy surrounding the ﬁscal theory by describing it in ways that do not get mired in interpretation of the contentious equilibrium condition. Instead, the paper takes a more microeconomic approach to show how the ﬁscal theory works in several conventional models. First, Section 2 uses a permanent income model to describe the ﬁscal theory mechanism in partial equilibrium terms. In Section 3 we...