Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 20 December 2015

The FTPL version of the Neo-Fisherian proposition

Probably for macroeconomists


The Neo-Fisherian doctrine is the idea that a permanent increase in a flat nominal interest rate path will (eventually) raise the inflation rate. It is then suggested that current below target inflation is a consequence of fixing rates at their lower bound, and rates should be raised to increase inflation. David Andolfatto says there are two versions of this doctrine. The first he associates with the work of Stephanie Schmitt-Grohe and Martin Uribe, which I discussed here. He like me is not sold on this interpretation, for I think much the same reason. (There is a closely related discussion of the Neo-Fisherian doctrine by John Cochrane, which I will refer to in a subsequent post on Woodford’s recent idea of reflective equilibrium.) But he favours a different interpretation, based on the Fiscal Theory of the Price Level (FTPL).


Let me first briefly outline my own interpretation of the FTPL. This looks at the possibility of a fiscal regime where there is no attempt to stabilise debt. Government spending and taxes are set independently of the level or sustainability of government debt. The conventional and quite natural response to the possibility of that regime is to say it is unstable. But there is another possibility, which is that monetary policy stabilises debt. Again a natural response would be to say that such a monetary policy regime is bound to be inconsistent with hitting an inflation target in the long run, but that is incorrect.


A simple example is a model without sticky prices where bonds are denominated in nominal terms, and a monetary policy that involves a constant nominal interest rate. A constant nominal interest rate policy is normally thought to be indeterminate because the price level is not pinned down, even though the expected level of inflation is. In the FTPL, the price level is pinned down by the need for the government budget to balance at arbitrary and constant levels for taxes and spending.


The idea still works even with sticky prices and indexed debt, as my EJ paper with Tatiana Kirsanova shows. Here the budget is balanced, after a positive shock to debt say, by a period of above target inflation which reduces real government debt through lower real interest rates. This raises a somewhat pedantic point about David’s post. I’m not sure the path he shows for inflation, with no inflation surprises and no period of lower real rates, would be sufficient to stabilise the government’s budget constraint. Unless I have missed something, a period of higher inflation is required to do this. 

However I have a much more serious problem with this FTPL interpretation in the current environment. The belief that people would need to have for the FTPL to be relevant - that the government would not react to higher deficits by reducing government spending or raising taxes - does not seem to be credible, given that austerity is all about them doing exactly this despite being in a recession. As a result, I still find the Neo-Fisherian proposition, with either interpretation, somewhat unrealistic.

14 comments:

  1. Typo I think: "I’m not sure the path he shows for inflation, with no inflation surprises and no period of lower real rates, would be [.]sufficient to stabilise the government’s budget constraint."

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    1. Nick - thanks. I do this kind of thing too often.

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  2. "Again a natural response would be to say that such a monetary policy regime is bound to be inconsistent with hitting an inflation target in the long run, but that is incorrect."

    If I am understanding correctly, I would say that it *is* inconsistent with hitting an inflation target, but that it *may* (for some values of existing nominal debt and PV of real primary surpluses) be consistent with a one-time jump up or down in the price level (to make the real debt consistent with those future real surpluses) and hitting the inflation target *thereafter*.

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    1. or by creating a path for real interest rates which hits both the inflation target and real debt. This can be done, because inflation is forward looking and debt dynamics is not.

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  3. "I’m not sure the path he shows for inflation, with no inflation surprises and no period of lower real rates, would be insufficient to stabilise the government’s budget constraint."

    Did you mean "sufficient"?

    What did you mean by "no inflation surprises" here? Are you talking about the path shown in his first chart - "Mild Neo-Fisherian View". Doesn't the initial movement in inflation in that chart reflect an inflation surprise?

    As to having no period of lower real rates, I think models such as John Cochrane's do have at least one period of lower actual real rates, even though that isn't a feature of the chart replicated in David Andolfatto's post.

    One way we might not need any period of lower actual real rates is if we were to factor in term debt. That would mean that a rise in expected nominal rates would reduce the nominal value of outstanding debt, reducing the current equilibrium price level and therefore requiring a temporary deflation. More on this here: http://monetaryreflections.blogspot.co.uk/2015/11/neo-fisherism-and-term-debt.html

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    1. Thanks for the correction. My comment was on David's path alone. You need an initial positive inflation surprise.

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    2. OK. But, as I said, if you factor in term debt, the budget constraint will stabilise even with a negative inflation surprise, because of the negative nominal revaluation.

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  4. Andolfatto laying out the theory plainly and candidly like that sure made its flaws very obvious. Still... +1 for clarity and honesty.

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  5. "He like me is not sold on this interpretation, for I think much the same reason."

    Why are you not sold on this interpretation?

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    1. The expectations mechanisms required seem contrived. More detail in my post tomorrow.

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  6. I think St Louis FED summed it up. "Policymaker conventional wisdom and NK theory both suggest low nominal rates should cause inflation to rise. The simple empirical evidence reviewed here suggests this is not happening even after 6.5 years of ZIRP. There are still reasons for maintaining faith in the conventional wisdom, including a major oil price shock and arguably anchored inflation expectations. The general result from the learning literature on the local instability of the LL steady state seems unhelpful—it predicts a natural return of inflation."

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    1. Can you give me a link to this reference?

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    2. https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard-Expectations-in%20Dynamic-Macroeconomic-Models-08-13-2015.pdf

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