Inflation and Policy Rules

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The determination of the price level and inflation has long been a central concern for macroeconomists. This reflects the widespread view that the control of inflation is important for economic welfare. In view of its central importance, it is perhaps surprising that the basic determinants of the price level and inflation continue to be under dispute. Recently, this dispute has become more heated with the arrival of the "fiscal theory of the price level" which puts a new twist on the debate. The traditional, monetarist view has highlighted the importance of an independent central bank and has held that high inflation can only be ultimately fueled by high rates of money growth. In this view, the fiscal policy is important, but mainly so because excessive deficits may eventually force the central bank to monetize. According to the fiscal theory, the government can instead target directly the price level using fiscal variables alone, such as the present value of future surpluses and the current level of nominal debt.These two views stem from important differences in the equilibrium concept different researchers have in mind. The failure to reconcile these differences follows from the fact that a key feature of the economy, the price-formation mechanism, is left implicit. This project uses game theory to fully specify how prices arise from the actions of the government and the private players in the economy, without resorting to the fiction of a Walrasian auctioneer. In this environment, it is plainly impossible for the government to commit in advance to a sequence of primary surpluses/deficits that is independent of the actions of the private sector, except in a very special case. However, this negative conclusion on the key assumption of the fiscal theory of the price level does not extend to its key result: the price level can still be pinned down by the fiscal policy. When money is explicitly modeled, the traditional result linking inflation to high money growth rates is restored; however, the fiscal theory leads to a unique equilibrium even with an interest rate peg, which was previously commonly associated with price indeterminacy.Spelling out completely the assumptions on the government strategy that lead to a fiscal theory of the price level is very important for policy advice. Previous papers on the subject claimed that price stability could be achieved by a firm commitment by the government to ignore any debt crisis and pursue a policy of exogenous and fixed surpluses/deficits. This project shows that in a debt crisis a fiscal adjustment is forced onto the government. The appropriate advice for achieving price determinacy through the fiscal side of the economy calls for more taxes during the crisis without any tax cut ever. Such a strategy would make the expectations of a debt crisis self-defeating, but both the ability to commit to it and the credibility of such a commitment might be much more problematic than what is needed for the policy rule advocated by previous papers.From a theoretical perspective, the approach developed here is valuable for a wider class of problems. This project shows that there is a fundamental tension between the description of a policy rule, which specifies how the government should react under all contingencies, and the definition of a competitive equilibrium used in macroeconomics, that only describes equilibrium allocations and prices. A game-theoretic description of the economy can thus be useful to revisit the vast literature that studies how the adoption of a particular policy rule can avoid or cause equilibrium indeterminacy.