11/2/2018 MacroMania: Fiscal theories of the price-level

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Thursday, February 8, 2018

David Andolfatto

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Fiscal theories of the price-level opinions expressed by me in
this blog are my own and
This post is me thinking out loud about how fiscal considerations may influence the price-level. The should in no way be attributed to the Federal
question of what determines the price-level is an old one. It's a question that economists struggle Reserve Bank of St. Louis, or to the Federal
with to this day. Reserve System.
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To begin, what do we mean by the price-level? Loosely, the price-level refers to the "cost-of-living,"
where cost is measured in units of money. Living refers to the flow of services consumed (destroyed)
for the purpose of survival/enjoyment. (Note that the cost-of-living might alternatively be measured
as the amount of labor one must expend per unit of consumption, but this would require a separate CME FedWatch Tool
discussion.)

Measuring aggregate material living standards is challenging for two reasons. First, people consume Policy Uncertainty Index
a variety of goods and services. Suppose that the price of food goes up and the price of shelter goes
down. Does the cost-of-living go up or down? Second, different people have different material
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needs/wants (and individual wants and needs change over time too). Statisticians do the best they
can to address these complications by constructing "average consumption bundles" as done in the
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calculation of the Consumer Price Index (CPI). The following diagram plots the change in the price-
level (the inflation rate) for several categories of goods and services:

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In what follows, I'm going to abstract from inflation and focus only on the theory of the price-level
(inflation is the rate of change in the price-level over an extended period of time). To this end, think of
a very simple world where the real GDP (y) is fixed and determined exogenously (independent of
monetary policy). Assume that the expected rate of inflation is zero. Then, by the Fisher equation,
the nominal interest rate corresponds to the real interest rate. I want to think of this interest rate as

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11/2/2018 MacroMania: Fiscal theories of the price-level
being potentially influenced by monetary policy (I like to think of r as representing the real yield on
treasury debt, where treasury debt possesses a liquidity premium.)

Perhaps the oldest theory of the price-level is the so-called Quantity Theory of Money (QTM). It
seems clear enough that people and agencies are willing to accept and hold money because money
facilitates transactions--it provides liquidity services. In the simplest version of the QTM, the demand
for real money balances takes the form L(y), where L is increasing in y. The idea here is that the CPI +2.1 % Chg. from Yr.
demand for liquidity is increasing in the level of aggregate economic activity (as indexed by y). Ago on Dec 2017

Next, the QTM assumes that the supply of money (M) is determined by the central bank. Let P Civ. Unemploy. Rate 4.1
denote the price-level. Then (M/P) denotes the supply of real money balances. The QTM asserts % on Jan 2018
that the price-level is determined by an equilibrium condition which equates the supply of real money
balances with the demand for real money balances. Mathematically, 10-Yr. Treas. Rate 2.85
% on 2018-02-08
[1] M/P = L(y)
Real GDP +2.6 %, Comp.
Condition [1] can be explained as the consequence of the "hot potato" effect. The idea is that Annual Rate of Chg.
someone must be willing to hold the extant money supply. If M/P > L, then the money supply on Q4 2017
exceeds money demand. In this case, people will presumably try to dispose of their money holdings
(by spending them on goods and services). People accepting money for payment will be thinking the IP +0.9 % Chg.
same thing--they are willing to accept the money, but only selling their goods at a higher price. The on Dec 2017
"hot potato" effect ceases only when condition [1] holds. The same logic applies in reverse when M/P
< L (with everyone wanting to get their hands on the potato). Payroll Employment
+200 Chg., Thous. of
Persons on Jan 2018
Now, suppose that y varies over time. Then the QTM suggests that a central bank can keep the
price-level stable at P0 by letting the money supply move in proportion to money demand; i.e., M =
L(y)*P0. This is what is meant by "furbishing an elastic currency." This reminds us as well that
interpreting money-price correlations in the data are tricky if money demand is "unstable." ... and 508,000+ more
i i FRED

O.K., so now let's see where fiscal policy fits in here. Let D denote the outstanding stock of
government debt. If a central bank is restricted to create money only out of government debt, then
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we can write M = θD, where 0 < θ < 1 is the fraction of the debt monetized by the central bank. If the
central bank wants to increase the money supply, it would conduct an "open market operation" in ▼ 2018 (3)
which it buys bonds for newly-issued money, resulting in an increase in θ. Note that the money ▼ February (1)
supply may increase through changes in D for a constant θ.
Fiscal theories of the price-level

Let B denote the bonds held by the private sector (i.e., not including the bonds held by the central ► January (2)
bank). That is, B = (1 - θ)D. The interest expense of the public debt is given by rB. Note, while the
treasury actually pays an interest expense rD, the interest payments to the central bank rM are ► 2017 (12)
remitted to the treasury, leaving a net cost equal to rB = r(D-M). Thus, the central bank is in a ► 2016 (19)
position to lower the interest expense of the public debt by monetizing a larger fraction of it (I discuss
this in more detail here and here.) To the extent that the central bank influences r, it is also in a ► 2015 (25)
position to lower the interest expense by lowering r. ► 2014 (24)
► 2013 (32)
Now let's write down the government "budget constraint." Let T denote tax revenue (net of transfers)
and let G denote government purchases (of goods and services). Then, assuming that default is not ► 2012 (41)
an option, the government budget constraint is given by, ► 2011 (56)
► 2010 (70)
[2] T = G + rB
► 2009 (31)
The difference T - G is called the primary budget surplus (deficit, if negative). So another way to read ► 2008 (1)
[2] is that the interest expense of the government debt must be financed with a primary surplus. Note
that if r < 0, then the government is in a position to run a perpetual primary deficit. (The more general
condition is r < g, where g is the growth rate of the economy, which I've normalized here to be zero.)
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In most monetary models, the fiscal policy plays no role in determining the price-level. The reason
for this lies in the implicit assumption that taxes are non-distortionary (e.g., lump-sum) and that the
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fiscal authority passively adjusts T to ensure that condition [2] holds. This latter assumption is
sometimes labeled a Ricardian fiscal regime. In a Ricardian regime, fiscal policy does not matter for
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the price-level. To see this, suppose that the central bank increases r. Then the fiscal authority
increases T (or decreases G) with no change in the money supply or price-level. Or, imagine that the
fiscal authority increases D. In this case, the central bank can keep the money supply constant by
lowering θ, the fraction of debt it chooses to monetize. If so, then B will increase. In a Ricardian
regime, the fiscal authority will again either increase T (or decrease G), leaving the price-level
unchanged.

But suppose fiscal policy does not behave in the Ricardian manner described above. To take an
example, suppose that the fiscal authority instead targets T, or T-G, or (T-G)/P, etc. For
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concreteness, suppose it targets the real primary surplus τ = (T-G)/P. In this case, condition [2] can
be written as,

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[3] τ = r(B/P)

Condition [3] forms the basis of what is known as the fiscal theory of the price-level (FTPL); see
Cochrane (1998). The idea is as follows. Imagine a world where there is no need for money (a
cashless economy), so that condition [1] is irrelevant. Imagine too that the real rate of interest is
determined by market-forces, so that r > 0 represents the "natural" rate of interest. Finally, imagine
that the outstanding stock of debt D = B is nominal. Then the price-level is determined by condition
[3] which, while resembling a government budget constraint, is in fact a standard stock-valuation
equation. To see this, rewrite [3] as follows,

[4] (B/P) = τ/r

The right-hand-side of [4] represents the present value of a perpetual flow of primary government
budget surpluses τ. The left-hand-side of [4] measures the real value of the government's debt. The
equation [4] asserts that the real value of government debt is equal to the present value of the
stream of primary surpluses. This is analogous to the way one might value the equity of a company
that generates a stream of profits τ.

Note that condition [4] looks a lot like condition [1]. We can use the same "hot potato" analogy to
describe the determination of the price-level in this case. For example, suppose that (B/P) > τ/r. Then
people and agencies will presumably want to sell the over-valued government debt (for goods and
services). People are willing to accept these nominal claims, but only if they are sold more cheaply--
that is, if the goods sold to acquire the bonds can be sold at a higher price. As before, this hot potato
effect ceases only when condition [4] holds.

I'm still not sure what to think about the FTPL. While I lean more toward the QTM view, I do believe
that fiscal considerations can have an important influence on the price-level. The way I'm inclined to
think about this, however, is as follows.

Since nominal government debt represent claims against government money, it's not surprising that
such debt inherits a degree of "moneyness." To the extent this is true, the measure of money M used
in equation [1] should be expanded to include the liquid component of government debt. Let X < B
denote the liquid component of government debt. There are a few ways to think about this. One
obvious way is to imagine that the banking sector creates deposit liabilities out of X. Or we could
imagine that X is accepted directly as payment for goods and services, at least, for a subset of
agencies (China, for example, effectively exports goods and services for X). In any case, the
appropriate measure of money is given by M + X. In the limiting case where X = B, the relevant
money supply becomes the entire government debt D = M + B, so that condition [1] becomes,

[5] D/P = L(y)

In a world where government debt becomes increasingly more relevant as an exchange medium
than central bank money, control over the money supply is effectively transferred to the fiscal
authority. This is another sense, distinct from the FTPL, in which fiscal policy might influence the
price-level. The difference boils down to the source of money demand -- is it primarily liquidity-
preference, or is it because money/debt instruments are viewed as tax-backed liabilities?

There is, of course, much that I've left out here. While the assumed invariance of real economic
activity to monetary and fiscal policy is not a bad place to start for the question at hand, it is clearly
not a good place to end. As well, the model should be extended to permit sustained inflation. All of
this can be easily done and I'll try to come back to it later.

Something I do not think is critical for the issue at hand is modeling private money creation (beyond
the monetization of government debt modeled above). To the extent that banks monetize positive
NPV projects, the money they create out of private assets (in the act of lending) creates value that is
commensurate with additional liabilities created. In short, accretive share issuances (good bank
loans) are not likely to be dilutive (inflationary). Of course, the same is true of newly-issued
government money if the new money is used to finance positive NPV projects (including the
employment of labor in cases of severe underemployment).

Posted by David Andolfatto at 8:22 PM

14 comments:
Ralph Musgrave February 9, 2018 at 5:14 AM

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Can’t see anything wrong with the Warren Mosler model which can be set out in about 100
words, and which I think he sets out in his “Soft Currency Economics”. It goes like this.

The private sector wants a stock of state liabilities (base money and government debt). The
more of that stock that the private sector has the more it will tend to spend, which raises
demand. If the state issues MORE than the stock that the private sector wants, the state (i.e.
central bank and or government) it will have to pay interest in order to stop the private sector
trying to spend away the excess. Ergo the state could perfectly well issue a stock of
liabilities such that it did not pay any interest and yet induced the private sector to spend at a
rate that brings full employment.

That’s about it.

Re privately issued money (not something Mosler considers in so much detail), that will tend
to cut interest rates because it costs private banks nothing to obtain that money, whereas
under a "state money only" regime (i.e. full reserve banking) private banks can only obtain
money by borrowing it or earning it. The right that private banks have to create or "print"
money is actually a subsidy of private banks: one that should be banned. See:

https://seekingalpha.com/article/4127496-bank-subsidy-one-mentions

Reply

Replies

David Andolfatto February 9, 2018 at 3:10 PM

I will have a look, thanks Ralph.

Reply

JP Koning February 9, 2018 at 6:38 AM

"In most monetary models, the fiscal policy plays no role in determining the price-level. The
reason for this lies in the implicit assumption that taxes are non-distortionary (e.g., lump-
sum) and that the fiscal authority passively adjusts T to ensure that condition [2] holds. This
latter assumption is sometimes labeled a Ricardian fiscal regime. "

Can you give some colour on the former assumption too? ie the assumption that taxes are
non distortionary?
Reply

Replies

David Andolfatto February 9, 2018 at 3:12 PM

Consider the Friedman rule. It prescribes using a lump-sum tax to finance interest
on money (or, equivalently, to destroy zero-interest money at a rate that produces
deflation). Without that lump-sum tax instrument, financing such a monetary
policy would be more complicated.

Reply

anon February 9, 2018 at 9:10 AM

You write: "Something I do not think is critical for the issue at hand is modeling private
money creation (beyond the monetization of government debt modeled above). To the
extent that banks monetize positive NPV projects, the money they create out of private
assets (in the act of lending) creates value that is commensurate with additional liabilities
created. In short, accretive share issuances (good bank loans) are not likely to be dilutive
(inflationary)."

Shouldn't this be: As long as we can assume that banks only monetize positive NPV
projects, then it is not critical to model private money creation.

In short, if we don't trust the regulation of banks' asymmetric information to prevent banks
from originating, monetizing and selling "bad" assets, then we need to model the

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macroeconomic effects of private money creation. Do you agree?

Carolyn Sissoko
Reply

David Andolfatto February 9, 2018 at 3:13 PM

Broadly speaking, I agree. On the other hand, I suppose this is the role that equity plays.
Bank money takes the form of debt, the capital buffer could be used to absorb the losses
that banks make on bad loans.
Reply

anon February 9, 2018 at 3:24 PM

"Bank money takes the form of debt"

With the right regulation this would be a true statement. In fact, banks nowadays are allowed
to commit to expand their deposits on demand -- and these commitments are treated in a
FDIC resolution as equally as binding as deposits themselves. Thus, bank guarantees are
arguably just as much "bank money" as bank debt itself. These guarantees go by various
names: acceptances, letters of credit, liquidity facilities, etc. And they are usually drawn
down, if at all, by troubled entities.

The idea that the capital buffer is adequate to absorb losses on these guarantees was
tested 2007-08 and found wanting for several very large banks.

Carolyn Sissoko

Reply

Derek February 9, 2018 at 8:52 PM

Sorry if I am imposing... The "hot potato" idea that people try to get rid of excess money,
seems backwards to me. It seems like spending is driven by acquisition. So excess money
would be idle until someone figures out something to spend it on. Perhaps investors behave
differently, because they are always in the investment mindset.

If increased money does not increase spending, velocity decreases in the exact proportion
by which the money supply increased. But really, the existing money is circulating just as
before, while the additional new money increase just sits idle on the side.

This hearkens back to deep questions that marx and others have asked about surplus
product. Steve Keen has a video titled "Dialectic as a foundation for a dynamic non-
equilibrium monetary economics", where he explores this in depth. Specifically, he describes
2 different circuits of exchange between Money and Commodities. The C->M->C circuit is
qualitative, and the M->C->M+ circuit is quatitative.(he explains this at 59:30 in the video).
Investors ask how they can increase their quantity of money, through investment, while the
average joe asks how he can qualitatively improve his comfort by exchanging his commodity
of time for consumer goods.

The overarching thesis of Keen's work is something he calls "debt deflation". I interpret this
as not necessarily a decrease in price levels, but an increase in the burden and difficulty of
that qualitative exchange of commodities for the averge Joe. Prices don't drop too far,
because resources are controlled through debt and capture, but they don't rise either,
because the economy is limited by sales, and more product is produced immediately,
without overwhelming capacity to the point that competing firms increase prices.

Inflation is complex. You do a good job of explaining some valuable ideas, I was just
wondering if you had thoughts on Keen's work and others like him who try to start from a
different conceptual angle.
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David Andolfatto February 10, 2018 at 11:37 AM

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You're not imposing, thanks for your question. I think it's a good idea to explore
different ways of thinking about the determinants of inflation. I have not read
Keen's work in this area, though he has promised to send me a set of notes
outlining his core macro model. Perhaps these will contain his theory of inflation
too.

Reply

Nick Edmonds February 10, 2018 at 2:48 AM

One way private money might come into play is as follows:

Rather than the conventional QTM or your extended D/P = L(y), the dominant stock-flow
ratio might be something like (D + A) / P =L(y), where A is privately issued high quality liquid
assets. Then if lending criteria are relaxed we might see an increase in A/P requiring a rise
in P (to reduce D/P).

This depends on the extent to which private label assets are seen as substitutes for public
ones, something that is probably quite relevant to the period leading up and during the GFC.
Reply

Replies

David Andolfatto February 10, 2018 at 11:27 AM

In the models of private money I've seen, something like the fiscal theory of the
price-level is at work. Essentially, if A is used to finance a flow of output, then the
supply of liabilities is matched by a corresponding flow of output (loosely, the
supply of money increases in proportion to the supply of output, leaving the price
level unchanged). I have an old set of notes here that may or may not be of help:
http://www.sfu.ca/~dandolfa/inside.pdf

Reply

Stephen Williamson February 10, 2018 at 10:04 AM

This is a good start in thinking about why we have central banks, whether we should have
them, and the future role for central banks as transactions technologies change.
Economically, what we should care about is the whole spectrum of consolidated government
debt, from currency and reserves, through government debt of different maturities.
Traditionally, central banking has evolved so that the typical arrangement is a more-or-less
independent central bank with a monopoly on currency issue (and reserves too - they play
an important role in payments arrangements), and the power to conduct swaps of its
liabilities for the liabilities of the fiscal authority. And the fiscal authority makes decisions on
debt management - what maturities and how much of each maturity of interest-bearing debt
to issue. Historically, the power of the central bank comes from the special nature of its
liabilities - determined mainly through its monopoly on currency issue. So here I'm going to
differ with David - I think the competing private means of payment and debt instruments are
very important. Quantity theory ideas are deeply embedded in how central bankers think
about policy - typically open market purchases are thought to increase prices, and growth in
the stock of central bank liabilities is thought to lead to inflation. Of course, recent history
might make you think twice about that. But, government debt seems to play a special role
without any explicit restrictions on the issue of private debt. For example, government debt
is the dominant form of collateral in the repo market. So, liquidity is just a matter of degree.
And some assets that are liquid in some markets are not liquid in others. For example,
currency is useful in retail payments, but useless for interbank transactions. It's currently
hard to draw the line between what we think is monetary policy and what we think is fiscal
policy. For example, QE looks like debt management, so is that fiscal policy? And what if
currency were eliminated (Ken Rogoff might be happy)? Could the central bank control
inflation simply by pegging an interest rate on its own interest-bearing liabilities? What if we
let the central bank issue a full spectrum of interest-bearing, tradeable securities? Would
that be a good thing? We can make some guesses about these things, but there is currently
little research that gives us answers.
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David Andolfatto February 10, 2018 at 11:14 AM

Excellent points and questions, Steve.

I think we can all agree that liquidity is a matter of degree. One question I have in
regard to this observation is whether any sensible theory of the price-level should
recognize this fact, or whether it suffices to restrict attention to the supply of
nominal outside assets (or even a subset of such assets, like government
currency). Any thoughts on this?

Stephen Williamson February 10, 2018 at 4:00 PM

There's no good reason to restrict attention to any class of assets, as far as I can
tell.

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