A Ricardian Perspective of the Fiscal Theory of the Price Level

On the basis of a model on time consistent interaction of monetary and fiscal policy, we propose a positive theory of government debt and inflation. The basic take is that the long-term level of public liabilities can be explained as the endogenous outcome of a dynamic game played between two interacting macroeconomic policy makers: a central bank and a fiscal authority. We assume a â€conservative†central bank that puts excessive weight on an inflationary loss term, but is also responsive to general economic conditions as measured by consumer welfare. On the other hand, the behavior of the fiscal authority is governed by its relative impatience, which we see as resulting from dynamic frictions in the political process. This gives rise to profligate fiscal policies and introduces a strategic conflict between the two authorities about the path of the economy. The Markov-perfect equilibrium outcome of the resulting dynamic game is a path of real debt that converges to a finite positive level and is associated with a steady state inflation bias. This inflation bias is the result of the fiscal authority gaining leverage over the nominal properties of the equilibrium allocation. Thus, our model can be seen as providing a game-theoretic foundation for the propositions made in the fiscal theory of the price level