The Grumpy Economist: Fiscal Stories

financial stories is a new article, the second attempt to write an essay on fiscal theory for the Journal of Economic Perspectives.

The main concept is to explain the fiscal theory of the price level without any equations, by applying it, seeing how it can explain and interpret a wide range of historical episodes. Abstract:

Fiscal theory states that the price level adjusts so that the real value of government debt equals the present value of real primary surpluses. Monetary policy remains important. The central bank may set an interest rate target that determines expected inflation, and news of the present value of the surplus triggers unexpected inflation. I present fiscal theory by offering interpretations of historical episodes, including the gold standard, the currency peg, the end of hyperinflation, the achievement of inflation targets, the rise and fall of inflation in the 1970s and 1980s, the long quiet zero-bound of the 2010s, and inflation 2021–2022. Going forward, fiscal theory warns that inflation will have to be tamed through coordinated monetary and fiscal policy.

I thank Eric Hirst and Tim Taylor for the concept. Most of the stories are taken from Fiscal theory of the price level, but pulling them out, gathering them in one place, and simplifying them is a great idea. Key Idea

I think about how fiscal theory can explain important episodes. The first goal is expositional: with the help of this method, we can understand how fiscal theory works and what refinements it may need. The second goal is more serious: the analysis of episodes is a crucial way to evaluate all macroeconomic models.

I mostly tell believable stories rather than summarizing well-researched and published economic history or quantitative analysis. Fiscal theory is new, and this work is just beginning. But stories rightfully come first. Formal analysis is always based on plausible stories. Moreover, that there are such plausible stories that they provide a framework that can possibly explain the story, as MV=PY and IS-LM do, is news, since many people believe that fiscal theory can be quickly debunked. well-known episodes. I also hope to inspire detailed analysis.

The paper also shows the results of a good model, and this model is hidden in a footnote, which explains the basics of fixed price fiscal theory in a simpler way than I did in FTPL. Schedule:

Figure 1: Reaction of inflation and output in a simple rigid price model based on fiscal theory. Top: 1% deficit shock at constant interest rate. Bottom: interest rate shock with permanent surplus

With these charts, you can think through a lot of fiscal theories. The first chart is a fiscal shock with no interest rate change, something like what I think we saw in 2021. This leads to prolonged inflation and devaluation of outstanding bonds with a period of negative real interest rates. The second graph is an increase in the interest rate without a change in the surplus. This gives a temporary reduction in inflation. Reality combines two graphs. A Fed rate hike would add a second schedule to the first, which would help. A little. For some time.

Yes, repackaging the same ideas in many different ways. I hope to find one that works, or at least offer different packages for different tastes.

I’m not sure about the title yet. Fiscal fables? Financial bedtime stories? ; )


Model $$\begin{aligned}x_{t}&=E_{t}x_{t+1}-0.5(i_{t}-E_{t}\pi_{t+1})\\\pi_ {t}&=E_{t}\pi_{t+1}+0.5x_{t}\i_{t}&=i_{t-1}+\varepsilon_{i,t}\\rho v_{ t+1}&=v_{t}+r_{t+1}^{n}-\pi_{t+1}-\tilde{s}_{t+1}\\E_{t}r_{t +1}^{n}&=i_{t}\\r_{t+1}^{n}&=0.9q_{t+1}-q_{t}\end{aligned}$$ where \ (x \) = output gap, \(i\) = interest rate, \(\pi\) = inflation, \(v\) = real value of government debt, \(r^n\) = nominal yield of government debt, \ (\ tilde {s} \) = real primary surplus scaled by debt, \ (q \) = log price of government debt. The debt has a geometric repayment structure with a coefficient of 0.9. I build the response to unexpected \(\sum_{j=0}^\infty \rho ^j{\tilde {s))_{1+j}=-1\) and \(\varepsilon_{i,1}= one \).