Explaining the Fiscal Theory of the Price Level

Many traditional macroeconomic models do not have determinate predictions for the path of inflation: even for a given specification of money supplies, many paths of inflation are consistent with equilibrium. According to the fiscal theory of the price level, fiscal policy can be used to select which of these many paths actually occur. This article explains the fiscal theory of the price level and discusses its empirical and policy implications. The article argues that the theory is equivalent to giving the government an ability to choose among equilibria. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. How can governments influence inflation rates? Economists’ standard answer is that the central bank controls the inflation rate through its ability to control the money supply. In particular, if output grows at γ percent per year and the money supply grows at µ percent per year, then, at least over sufficiently long periods of time,