Working Paper: NBER ID: w22979
Authors: John H. Cochrane
Abstract: The fiscal theory of the price level can describe monetary policy. Governments can set interest rate targets and thereby affect inflation, with no change in fiscal surpluses. The same basic mechanism describes interest rate targets, forward guidance, open market operations, and quantitative easing. It does not require any monetary, pricing, or other frictions. In the presence of long-term debt, higher interest rates lead to temporarily lower inflation, a challenging sign. I derive and replicate the results of the Sims (2011) “stepping on a rake” model, which first produced this negative sign, and produces realistic impulse-response functions. I show that Sims' result is robust to many model features, but essentially requires long-term debt.
Keywords: No keywords provided
JEL Codes: E31; E4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher nominal interest rates (E43) | Lower inflation (E31) |
| Higher nominal interest rates (E43) | Lower market value of outstanding government debt (H63) |
| Lower market value of outstanding government debt (H63) | Lower aggregate demand (E19) |
| Lower aggregate demand (E19) | Decline in price level (E31) |
| Higher nominal interest rates (E43) | Lower price level (E30) |
| Long-term debt (H63) | Negative inflation response to rising interest rates (E31) |
| Stepping on a rake effect (C92) | Transitory decline in inflation (E31) |
| Transitory decline in inflation (E31) | Eventually increase as Fisher effect takes hold (E43) |