A Demand Theory of the Price Level

Marcus Hagedorn

No 11364, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: In this paper, I show that heterogeneous agent incomplete markets models offer a new perspective on several issues in monetary economics. Monetary policy is assumed to work through setting nominal interest rates, e.g. an interest rate peg or an interest rate rule, while fiscal policy is committed to satisfying the present value budget constraint at all times (in contrast to the Fiscal Theory of the Price Level). I show that prices and inflation are jointly and uniquely determined by fiscal and monetary policy in this environment. The price level is determinate, even for a fixed nominal interest rate, while the corresponding complete markets model requires interest rate feedback rules satisfying the Taylor principle for determinacy. In contrast to the conventional view, the long-run inflation rate here, in the absence of output growth, and even when monetary policy operates an interest rate rule with a different inflation target, is equal to the growth rate of nominal fiscal variables, which are controlled by fiscal policy. The conclusion deals with some of the new perspectives that this novel theory offers, including new answers to several puzzles which arise in New Keynesian complete markets models during a liquidity trap.

Keywords: Incomplete markets; inflation; Monetary policy; Fiscal policy; Zero lower bound; Fiscal multiplier; Forward guidance (search for similar items in EconPapers)
JEL-codes: D52 E31 E43 E52 E62 E63 (search for similar items in EconPapers)
Date: 2016-06
New Economics Papers: this item is included in nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (15)

Downloads: (external link)
https://cepr.org/publications/DP11364 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Working Paper: A Demand Theory of the Price Level (2016)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:11364

Ordering information: This working paper can be ordered from
https://cepr.org/publications/DP11364

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().