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  • Print publication year: 2020
  • Online publication date: November 2020

4 - The Fallacy of the Fiscal Theory of the Price Level – and Why It Matters

Summary

Chapter 4 reviews how not to use the intertemporal budget constraint (IBC) of the State. It analyses why the fiscal theory of the price level (FTPL) is fatally logically flawed: it confuses the IBC of the State with a mis-specified equilibrium nominal government bond pricing equation.

The FTPL generates a number of anomalies and inconsistencies.

Anomaly 1: The price level can be negative.

Anomaly 2: If the public debt is index-linked and/or denominated in foreign currency, there is no FTPL.

Anomaly 3: The FTPL can price phlogiston – it can determine the general price level for a model in which money exists only as a numeraire.

Anomaly 4: If the logic of the FTPL holds, we could also have the Mrs. Jones Theory of the Price Level.

Anomaly 5: When we use the IBC of the State as an equilibrium sovereign debt pricing equation in the proper manner, the FTPL vanishes.

Anomaly 6: When viewed as an equilibrium selection criterion, the FTPL in general produces explosive or implosive solutions for the general price level and the rate of inflation when the nominal money stock is constant.

Inconsistency 1: If the FTPL is imposed as another equilibrium condition when the nominal money stock is exogenous and the fundamental equilibrium has been selected, then the model is overdetermined.

Inconsistency 2: When the price level is predetermined the FTPL results in an overdetermined system.

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