School of Economics

2010 Discussion Papers

School of Economics Discussion Paper 10/13
December 2010

Policy Rules Under the Monetary and the
Fiscal Theories of the Price-Level

Jagjit S. Chadha
University of Kent

Abstract:

Price-level determination requires co-ordination of monetary and fiscal policy to ensure a unique rational expectations equilibrium (REE). This paper derives a number of implications for simple interest rate rules resulting from various fiscal strategies. We show that fiscal choices under either the monetary theory of the price-level (MTPL) and the fiscal theory of the price-level (FTPL) can challenge widely accepted principles of monetary policy. Specifically, we show that a fiscal rule that responds aggressively to output and inflation may force the monetary authorities to adopt significantly more aggressive output and inflation stabilization policy than suggested by the Taylor Principle. We also show how when monetary policy is severely constrained, the fiscal policy maker can act to stabilise the economy. Some policy conclusions in light of the lower zero bound for monetary policy and debt stabilization are drawn.

JEL Classification: E21, E32, E52, E63

Keywords: Monetary and Fiscal Policy Rules; Ricardian, non-Ricardian fiscal policy

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