A Demand Theory of the Price Level

In this paper I propose a theory of a globally unique price level based on the simple idea that the price equates demand with supply in the goods market. Monetary policy through setting nominal interest rates, e.g. an interest rate peg, and fiscal policy, which satisfies the present value budget constraint at all times, jointly determine the price level. In contrast to the conventional view the long run inflation rate is, in the absence of output growth, equal to the growth rate of nominal government spending which is controlled by fiscal policy. This new theory where nominal government spending anchors aggregate demand and therefore current and future prices suggests a different perspective on the fiscal and monetary transmission mechanism, on policy coordination, on policies at the zero-lower bound and on U.S. inflation history.