DP11364 | A Demand Theory of the Price Level

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06/28/2016

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Abstract

In this paper I develop a simple incomplete markets model and show that the price level is globally determinate. Monetary policy works through setting nominal interest rates, e.g. an interest rate peg or an interest rate rule, while fiscal policy is committed to satisfying the present value budget constraint at all times (in contrast to the Fiscal Theory of the Price Level). Jointly, these policies determine the unique price level, as well as consumption and employment. In this new approach to price level determinacy several puzzles disappear which arise in New Keyensian models during a liquidity trap. Forward guidance has negligible output effects, the size of the fiscal multiplier decreases if prices are less sticky, and technological regress reduces output. Determinacy also enables a richer analysis of monetary and fiscal policy coordination. In particular, interest rates need not be raised aggressively whenever fiscal policy succeeds in stimulating inflation and demand.