Working Paper: CEPR ID: DP10240
Authors: Jingwen Fan; Patrick Minford; Zhirong Ou
Abstract: We investigate whether the Fiscal Theory of the Price Level (FTPL) can explain UK inflation in the 1970s. We confront the identification problem involved by setting up the FTPL as a structural model for the episode and pitting it against an alternative Orthodox model; the models have a reduced form that is common in form but, because each model is over-identified, numerically distinct. We use indirect inference to test which model could be generating the VECM approximation to the reduced form that we estimate on the data for the episode. Neither model is rejected, though the Orthodox model outperforms the FTPL. But the best account of the period assumes that expectations were a probability-weighted combination of the two regimes. Fiscal policy has a substantial role in this weighted model. A similar model accounts for the 1980s though the role of fiscal policy gets smaller.
Keywords: Fiscal theory of the price level; Identification; Indirect inference; Testing; UK inflation
JEL Codes: E31; E37; E62; E65
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Active fiscal policy (E62) | Inflation (E31) |
| Monetary policy (E52) | Inflation (E31) |
| Fiscal policy + Orthodox monetary policy (E63) | Expectations of inflation (E31) |
| Fiscal policy (E62) | Inflation (1980s) (E31) |