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The Failed Theory of the Price Level
CEPR
2024.01.29
The Fiscal Theory of the Price Level (FTPL) is a promise to obtain price level determinacy even if the nominal interest rate is constant. The idea is that a unique current price level ensures that the present value government budget constraint holds. I establish that this idea hinges on the presence of complete markets and that correspondingly, the FTPL fails to deliver on the price level determinacy promise in (dynamically efficient) overlapping generations (OLG) and incomplete market models, in which Ricardian equivalence fails. I show that the present value government budget does not determine the price level, in contrast to the FTPL logic. I also establish that the price level clears the asset market without imposing the key FTPL assumption that fiscal policy is active. I also explain that Kaplan, Nikolakoudis & Violante (2023) and Brunnermeier, Merkel & Sannikov (2023) do not seem to understand all aspects of determinacy, how the price level is determined in incomplete markets models or the mechanics of the Fiscal Theory of the Price Level.