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Monetary and fiscal theories of the price level: the irreconcilable differences

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Bennett T. McCallum
Edward Nelson

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Abstract

The fiscal theory of the price level (FTPL) has attracted much attention but disagreement remains concerning its defining characteristics. Some writers have emphasized implications regarding interest-rate pegging and determinacy of RE solutions, whereas others have stressed its capacity to generate equilibria in which price level trajectories mimic those of bonds and differ drastically from those of money supplies. We argue that the FTPL attained prominence precisely because it appeared to provide a theory whose implications differ greatly from conventional monetary analysis; accordingly we review monetarist writings to identify the primary distinctions. In addition, we review recent findings concerning learnability - and therefore plausibility - of competing RE equilibria. These indicate that when FTPL and monetarist equilibria differ, the latter are more plausible in the vast majority of cases. Under Ricardian assumptions, necessary for clear distinctions, theoretical analysis indicates that fiscal and monetary coordination is not necessary for macroeconomic stability.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2006-010.

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Date of creation: 2006
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Publication status: Published in Oxford Review of Economic Policy, Winter 2005, 21(4), pp. 565-83
Handle: RePEc:fip:fedlwp:2006-010

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Keywords: Monetary policy ; Fiscal policy;

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