Working Paper: CEPR ID: DP12769
Authors: Marcus Hagedorn
Abstract: In this paper I show that models in which government bonds are net wealth - that is, their value exceeds that of tax liabilities (Barro, 1974) - offer a new perspective on several issues in monetary economics. First and foremost, prices and inflation are jointly and uniquely determined by fiscal and monetary policy. In contrast to the conventional view, the long-run inflation rate here is, in the absence of output growth, and even when monetary policy operates an interest rate rule with a different inflation target, equal to the growth rate of nominal fiscal variables, which are controlled by fiscal policy. This novel theory also offers a different perspective on the fiscal and monetary transmission mechanism, policies at the zero-lower bound, U.S. inflation history, recent attempts to stimulate inflation in the Euro area and several puzzles which arise in New Keyensian modelsduring a liquidity trap. To derive my findings, I first use a reduced form approach in whichhouseholds derive utility from holding bonds. I prove how and for which policy rules theprice level is globally determinate, then showing that the reduced form results carry over toa Bewley-Imrohoroglu-Huggett-Aiyagari heterogenous agent incomplete markets model.
Keywords: price level determinacy; Ricardian equivalence; incomplete markets; inflation; monetary policy; fiscal policy; policy coordination
JEL Codes: D52; E31; E43; E52; E62; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fiscal policy (E62) | long-run inflation rate (E31) |
| growth rate of nominal fiscal variables (E62) | long-run inflation rate (E31) |
| independent central bank cannot ensure long-run price stability if fiscal policy is not aligned with monetary policy (E61) | long-run price stability (E31) |
| government bonds are net wealth (H63) | real aggregate demand (E00) |
| shifts in the stock of real public debt (H69) | real aggregate demand (E00) |
| real aggregate demand = aggregate supply (E00) | price level (E30) |
| fiscal and monetary policies (E63) | price level (E30) |
| fiscal policy and monetary policy rules (E63) | price level (E30) |