REAL%THEORY%OF%THE%PRICE%LEVEL% Background%

REAL%THEORY%OF%THE%PRICE%LEVEL%
Eric Leeper
Briefing, 21 September 2015
Background%
There are two basic tasks that macroeconomic policy—monetary and fiscal—has to achieve:
determine the aggregate price level and stabilize government debt. Without these, other tasks
become difficult or impossible. Conventional assignments give monetary policy the task of
controlling inflation and fiscal policy the job of stabilizing debt. From this conventional
assignment springs the now-standard institutional arrangements of independent central banks that
target inflation and fiscal authorities that choose spending and taxes to ensure fiscal
sustainability. Both the monetarist and modern new Keynesian perspectives that dominate
monetary policy thinking embody those conventional assignments.1
New research has discovered that assignments can be reversed with monetary policy
stabilizing debt and fiscal policy determining the price level. This insight has emerged by
modeling fiscal behavior with the same attention to detail that monetary theory accords to
monetary policy. Filling in the fiscal aspects of macroeconomic theory expands the class of
equilibria that can arise to address a broader set of issues and to shed fresh light on traditional
issues. The new perspective is called “the real theory of the price level” to distinguish it from a
purely monetary theory.2
The real theory of the price level builds on existing monetary and fiscal theory and is in that
sense a natural outgrowth of current thought. But the implications for how we treat monetary
versus fiscal policy, the empirical predictions and resulting policy implications, and the
intellectual framework with which we approach macroeconomic issues, are profoundly different
in certain circumstances. For that reason it is also a radical departure.3
Differences between traditional monetary theory and the new theory of the price level can be
understood through two equilibrium conditions that are central to price-level determination in all
models4
!! !! = !! !! !!!!!!!!!!!!!!!!!!!! 1
and
1
See, for example, Friedman (1956) and Woodford (2003).
The academic literature labels this new perspective “the fiscal theory of the price level,” but for reasons
explained below, “real theory” seems more descriptive. The new theory grew out of work by Leeper (1991), Sims
(1994), Woodford (1995), and Cochrane (1998), with significant contributions from Bergin (2000), Bianchi (2012),
Bianchi and Ilut (2014), Cochrane (2001, 2005, 2011, 2014), Davig and Leeper (2006), Eusepi and Preston (2013),
Leeper and Leith (2015), Sims (1999, 2013), and Woodford (2001), to mention a few. Intellectual predecessors
include Friedman (1948, 1960), Tobin (1961, 1969), Brunner and Meltzer (1972), Sargent and Wallace (1981), and
Wallace (1981).
3
By way of analogy we might look to general relativity that supplanted Newtonian gravitation, not so much by
contradicting as by providing a new paradigm that extended the existing theory. General relativity is a more
comprehensive theory, providing a new view of how the universe works, but it does so by extending Newtonian
theory to new domains while still giving the same predictions in the low-energy limit.
4
This exposition builds on Cochrane (2005).
2
1
!!!! !!! !!!!
!!
= !! !" !"#$%"!&! !!!!!!!!!!!!!!!!!!!(2)
where !! !!!! is shorthand for the dollar value of the outstanding government bond portfolio,
allowing for a maturity structure for bonds.
Condition (1) is the venerable equation of exchange: total nominal expenditures in a year,
PY, must equal the stock of money, M, scaled by the number of times each dollar is spent, V,
over that year. Friedman developed this identity into the quantity theory of money by deriving a
theory of money demand (or velocity).
The second condition is a valuation equation that equates the real market value of nominal
government liabilities to the expected present value of primary—net of interest payments—
budget surpluses. Condition (2) resembles an asset-pricing equation that links the value of an
asset to the expected discounted stream of cash flows: the “cash flows” that back government
liabilities are the real resources that the government extracts from the economy.5
Although both conditions hold in any equilibrium, they are conceptually quite different. The
equation of exchange is an identity that defines velocity; the valuation equation embodies
private-sector optimization, so it arises in equilibrium as prices and expected surpluses adjust.
Condition (1) is static (though many theories of velocity do introduce dynamics); the second
condition is intrinsically dynamic, linking outcomes today to anticipated policy choices over the
infinite future. Most importantly, (1) connects nominal objects—nominal spending to nominal
sales; the valuation equation connects nominal objects—government liabilities—to real actions
taken by government.
The last point about expression (2) leads us to label outcomes that emphasize the role of
condition (2) “the real theory of the price level.”
How%the%Real%Theory%of%the%Price%Level%Works%
The real theory of the price level can be thought of as generalizing currently popular moneyonly perspectives on how macroeconomic policies, together with private economic decisions,
determine the aggregate price of goods and services. Money-only theories—whether monetarist
or new Keynesian—make implicit and rarely explored assumptions about the behavior of fiscal
policy whenever those theories are invoked to interpret economic data or to deliver monetary
policy advice. 6 The real theory generalizes those views by emphasizing that it is always the
joint behavior of monetary and fiscal policy that determines aggregate prices and inflation.
One key insight that underlies the real theory is that ultimately the ability of government to
affect the relative price of goods and nominal government liabilities—that is, the aggregate price
level—lies in the power to tax. Taxes directly extract resources from the private sector and it is
that fiscal backing that gives fiat currency—an intrinsically useless object that the issuer does not
promise to convert into anything of value—its value in exchange.7 Lerner argues that “money is
a creature of the state,” deriving its value from the government’s willingness to accept money in
5
If the government generates seigniorage revenues, those revenues are included in primary surpluses.
“Money-only” is a convenient label for analyses that leave fiscal behavior implicit.
7
The government’s ability to extract resources by debasing the currency requires that the currency be valued in
the first place. Because no one is compelled to hold fiat currency, this channel cannot serve as a fundamental means
by which governments obtain resources.
6
2
payment of taxes: “[Money’s] general acceptability, which is its all-important attribute, stands or
falls by its acceptability by the state.”8
Recognizing the fundamental importance of fiscal policy does not deny monetary policy’s
importance in affecting macroeconomic outcomes. Instead, it refocuses attention on the joint
behavior of the two macroeconomic policy tools. By expanding the perspective to consider
monetary and fiscal policies jointly, the analysis uncovers a broader set of macroeconomic
equilibria than are typically studied. Those new equilibria can contrast sharply with money-only
outcomes.
A topical example comes from predicting the macroeconomic consequences of normalizing
interest rates. After seven years of near-zero federal funds rates, once the Federal Reserve senses
that inflation may begin to rise above its 2 percent target, the Fed will start to raise rates toward
their historic average levels. A higher federal funds rate generally raises all interest rates,
including those on U.S. treasuries. The money-only view sets aside this fiscal implication of
higher interest rates by implicitly assuming that future taxes will rise as needed to finance the
higher debt service with larger primary surpluses.9 By “neutralizing” the fiscal impacts, this
assumption leads to the money-only conclusion that higher nominal—and real—interest rates
will make current consumption more costly, reduce demand for goods, and, through a Phillips
curve mechanism, keep inflation in check.
But the fiscal implications are huge when, as now, government debt is near 100 percent of
GDP. In 2012, when the yield on 10-year Treasury bonds was 1.8 percent, interest payments on
the debt were 7.8 percent of federal expenditures. If yields rise to their 50-year average of 6.6
percent, debt service will consume 28.6 percent of the federal budget or over $1 trillion in 2012
dollars. To neutralize the aggregate consequences of this run-up in interest payments, future
taxes must rise by $1 trillion in present value. Those higher taxes offset the wealth effects of
larger interest receipts and permit the monetary policy tightening to reduce aggregate demand.
When higher taxes are not assured, higher wealth cancels monetary policy’s contraction and
inflation rises. The effectiveness of monetary policy rests on fiscal behavior.
A second insight which the real theory exploits is that it matters a great deal whether the
government issues real—indexed for inflation—or nominal debt. Real debt is a claim on goods
in the future, requiring the government to back the debt with resources obtained through taxes. If
a government cannot raise sufficient resources to pay off the debt, it has no alternative but to
default. Nominal debt is much like fiat currency: it is a claim to future dollars. So long as the
government controls monetary policy, it can always generate new dollars to meet debt service.
This distinction explains recent observations from sovereign debt markets. Starting in 2008,
but particularly since 2010, some members of the euro area—Greece, Portugal, Spain, Italy, and
Ireland—have seen large increases in their government bond yields relative to Germany. In the
cases of Portugal and Spain, yield spreads rose even at moderate debt-GDP levels. Japan’s
8
Lerner (1947, p. 313). This view is rooted in what Knapp (1924) called “chartalism,” the idea that fiat
currency has value because of the power of the sovereign to levy taxes that are payable in the currency the sovereign
issues. But even earlier Adam Smith (1904, chapter II, p. 311) acknowledged the fundamental importance of
taxation: “A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a
certain kind, might thereby give a certain value to this paper money; even though the term of its final discharge and
redemption should depend altogether upon the will of the prince.”
9
Of course, since primary surpluses service the debt, government spending could decline instead.
3
government debt, in contrast, is more than double its GDP, while debt in the United Kingdom
and the United States is near 100 percent, yet none of these countries face any risk premia in
their bond yields. Eurozone nations issue debt in euro, but the quantity of euro is controlled by
the European Central Bank rather than individual member nations. To those countries, their debt
issuances are effectively real, demanding real (tax) backing. When the backing is not assured,
default probabilities rise. Japan, the U.K., and the U.S. can always devalue their outstanding debt
through higher inflation or lower bond prices, just as condition (2) depicts.
We conclude with another example drawn from recent economic developments: what are the
consequences of an interest-rate peg? In his presidential address, Friedman warned that
“monetary policy cannot peg interest rates,” and that attempts to do so will lead to everincreasing money growth and inflation.10 Sargent and Wallace formalized the argument by
showing that under rational expectations a pegged interest rate leaves the price level untethered:
the public anticipates that monetary policy will accommodate whatever quantity of money is
demanded at the pegged rate; with real money balances pinned down by the pegged interest rate,
any increase in the price level will be met by an increase in the money stock to maintain the
desired level of real money balances.11 In his textbook, Sargent goes further to state: “There is no
interest rate rule that is associated with a determinate price level.”12
Since December 2008, the Federal Reserve has pegged the federal funds rate near zero, yet
there is no evidence that the U.S. price level has become unhinged from fundamentals. During
the Great Depression until the Treasury Accord in 1951, the Fed effectively pegged interest rates,
again without any apparent untethering of the price level.
The real theory of the price level provides an explanation for this apparent contradiction of
orthodox monetary theory with observation. Implicit in the Friedman-Sargent-Wallace argument
is the assumption that fiscal policy will adjust as needed to ensure that the drifting price level is
consistent with equilibrium. Condition (2) makes the required adjustment clear: a pegged interest
rate effectively pegs the bond price, !! ; any increase in the price level will reduce the real value
of outstanding government liabilities and require fiscal backing to shift down accordingly.
Money-only analyses automate this fiscal adjustment without scrutinizing its plausibility.
An alternative and at least as reasonable assumption is that there is no automatic adjustment
of surpluses to fluctuations in the price level. In both of the historic episodes when the interest
rate was pegged, fiscal policies were pursuing goals like economic stabilization, rather than debt
stabilization, making surpluses unresponsive to the value of government liabilities. In this case,
the present value in (2) is effectively fixed. If bond prices are pegged, then there is a single price
level that is consistent with equilibrium.
This example reconciles actual policy behavior with economic outcomes to deliver a result
that conventional monetary theory cannot address.
10
Friedman (1968, p. 5). See also Friedman and Schwartz (1963).
Sargent and Wallace (1975).
12
Sargent (1987, p. 463).
11
4
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