Wednesday, July 1, 2020

New "Fiscal theory of the price level" draft.

I posted a new draft of The fiscal theory of the price level, a slowly emerging book manuscript. It's heavily revised through Chapter 6.

Chapter 5 has a much better treatment of sticky price models. The mechanics of writing new-Keynesian + fiscal theory models are really easy. Invitation: there is a great paper-writing recipe in here! Chapter 6 includes empirical work, also ripe for extension. Both chapters summarize recent papers  A fiscal theory of monetary policy with partially repaid long term debt and The fiscal roots of inflation.

I've clarified and emphasized a point that's been floating around but not clearly enough: governments who borrow (deficits) do convince markets that they will subsequently repay debts (surpluses) at least in part. The surplus process has an s-shape, not an AR(1) shape. If governments do not do so, then they cannot raise revenue from bond sales, and they cannot finance deficits by selling debt.  The evident fact that they do both is some of the strongest evidence for an s-shaped surplus process. Much fiscal theory analysis, apparent rejections, and puzzles come down to ruling out this (with hindsight) simple fact, and also forgetting some lessons of 1980s time-series econometrics.

The book draft is up to solicit comments, which I welcome, best by private email. The links take you to a new website. I discourage browsing around for the moment as it is heavily under construction. I can't access my Booth website anymore, so a new one is coming but slowly.

Update: LAL, yes, thanks. (I can't seem to post comments on my own blog, so I have to answer here.)


  1. What... Prof, they kicked you out of the Chicago Booth portal because of your recent criticisms? :-) :-) :-) Just kidding. Looking forward to the book actually.

  2. Great. I've been doing a lot of logistic function calculating vis-a-vis the pandemic. Some of my former hedge fund colleagues are looking to its affect/effect on markets. The math is straight forward but the assumptions are thorny. Your monograph will be very helpful.

  3. Please give a dumbed-down explanation of the following:
    "The surplus process has an s-shape, not an AR(1) shape"

  4. M1 = abt 5.23 Tril, GDP = abt 20 tril, total tax = abt .25*GDP....hmmm

  5. “This bond sale could finance a deficit st, but it could also generate a disinflation, Et (Pt 1/Pt) < 0.” From page 31, is the inequality the right direction?

  6. If you may, I was writing a paper about a possible mechanism that can act as an alternative to these Sticky Price Models; the summary is like this:
    "Like the roles played by nominal rigidity and menu costs in the explanations of Phillips Curve, capital adjustment cost – which makes it difficult for firms to adjust capital to instantaneously equate the ratio to unity i.e. its equilibrium value - is offered as the primary reason for the persistence of disequilibrium (in the Q-Theory of investment). does not need such contrived assumptions to justify the existence of either of these two effects. We can remain faithful to rationality and market forces to be able to explain the emergence of these apparent anomalies within our received framework. Although I do not claim that these effects explain all the variance of the relevant variables.
    A causal chain can be developed directly from the interdependence between demand for labor, capital, and cash. Inflation reduces the real interest rate (The Mundell-Tobin Effect), which leads an appreciation in the real value of financial assets like stocks and bonds that finance capital assets – by lowering their discount rate. This pushes the demand for investment in capital machinery (the q-Effect), and also drive up the demand for labor and a rise in wage (the Phillips Curve Effect) to ensure optimality of conditional factor demand, thus forcing a reversion to the steady state in the long run. This explanation renders unnecessary the use of stickiness in prices to account for wage rises.
    This particular pattern is valid only for the case when labor and capital are gross complements i.e. if the elasticity of substitution σ between labor L and capital K is less than one and the production function is concave i.e. marginal products are diminishing in inputs. Increased investment in capital reduces the marginal product of capital until it equals the lowered real interest rate r prevalent in the financial markets. The reduction drives up the relative price of the other factor i.e. labor. With w as the wage rate, the relative share of factor income R=wL/rK necessarily increases in the total payments to labor"


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