The Fiscal Theory of the Price Level in New Keynesian Models with Capital

In this paper, I embed the fiscal theory of the price level (FTPL) in a simple continuous-time New Keynesian (NK) model with capital and capital adjustment costs. I offer an elaborate analysis of determinacy, model dynamics, transmission channels and the importance of capital adjustment costs in the continuous-time NK-FTPL framework. My results indicate that FTPL lives up to its name, as the exact specification of fiscal policy is crucial for model implications and predictions. Equipped with the fiscal theory, I evaluate the Great East Japan Earthquake of 2011 and show how to explain and solve the puzzling behavior of expansionary effects of capital destruction at the Zero Lower Bound of the nominal interest rate. I then address and solve the Crowding-In Consumption Puzzle that refers to a discrepancy between the empirically observed and theoretically predicted responses of consumption to government consumption shocks. My model supports consumption dynamics in either direction and at the same time suggest a crowding-in of investment. Finally, FTPL models in the literature usually introduce long-term debt in order to obtain a negative correlation between inflation and the nominal interest rate. I show that the inclusion of capital and its effect on fiscal policy rules is able to induce the negative correlation even under short-term debt