Does the Fiscal Theory of the Price Level explain US postwar behaviour?
Vo Phuong Mai Le,
David Meenagh,
A. Patrick Minford and
Michael Wickens
No E2024/17, Cardiff Economics Working Papers from Cardiff University, Cardiff Business School, Economics Section
Abstract:
We implement a quantitative empirical test of the Öscal theory of the price level (FTPL) model via indirect inference, comparing it to a standard New Keynesian model. The FTPL alternative creates a serious instability problem because it triggers a ëdoom loopÃin which ináation pushes up interest rates which in turn pushes up deficits and debt and so ináation. Without some sort of endogenous feedback response this instability prevents the model even from solving in finite space. This is the case whether we embed FTPL in an otherwise conventional New Keynesian model or in a classical RBC model. We then went on to look for endogenous responses of government spending and tax to the economy - a Fiscal Rule - which might render the FTPL model su¢ ciently stable to be testable. We found such a Rule: in it spending stabilises the output gap while tax responds to ináation, with an ináation cap ('tax reform') - such that if ináation exceeds some high rate it overrides the FTPL terminal condition by inserting whatever terminal surplus will cap ináation at this rate. With this rule in place we can solve ann RBC version of the model without triggering intolerable volatility. Finally, we test this version after reestimating it with the best available parameters. It is on the rejection borderline on our full postwar sample.
Pages: 34 pages
Date: 2024-08
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