In ation, Equilibrium and Government Commitment

This paper stems from a recent heated debate on the relationship between the price level and scal policy. While the relationship between in ation, government de cits and debt has a long tradition in macroeconomics, a recent string of papers has put a new twist on it by proposing a \ scal theory of the price level", which shows that the government can target directly the price level by using scal variables, such as the present value of future surpluses and the current level of nominal debt. At stake are some basic ideas about how to control in ation. The traditional view has highlighted the importance of an independent central bank and has held that high in ation can only be ultimately fueled by high rates of money growth. In this view, the scal policy is important, but mainly so because excessive de cits may eventually force the central bank to monetize. According to the scal theory, the price level is primarily determined by de cits and the debt alone, and a central bank that successfully keeps a low money growth rate even for ever may actually force the economy into a hyperin ation spiral. In this case, price stability calls much more for a responsible scal policy accompanied by nominal interest-rate targeting. The key di erence between the scal theory and the traditional view lies in the interpretation of the government budget constraint, which links the real value of debt to the present value of primary surpluses the government will run in the future. The advocates of the theory view this link as an equilibrium condition: an imbalance between the real value of debt and the surpluses would trigger changes in the price level that would lead back towards an equilibrium, either by reducing or by increasing the value of the nominal debt. The traditional view interprets the link