Stepping on a rake: The role of fiscal
policy in the inflation of the 1970s.
Chris Sims
Discussion
Frank Smets
European Central BankInternational ConferenceBank of Japan
28/29 May 2008

Overview• The fiscal theory of the price level (FTPL):– Fiscal shocks determine the price level;– Interest rate tightening will be counterproductive andlead to an increase in inflation.

• Empirical evidence on impulse responses• Normative analysis?
• The monetary/fiscal policy framework in EMU

Understanding the FTPL
• Leeper: Passive Monetary policy (PM, e.g. interestrate peg) and Active Fiscal policy (AF, e.g.
exogenous primary surplus) delivers a uniqueequilibrium with a stable price level. Fiscal policy
shocks determine the price level (FTPL).
• Sims:– Section III.2: Continuous-time flexible-price example.
– Section III.3: Model with bells and whistles: sticky prices,
habit formation, long-term debt, …

Understanding the FTPL: Flexible prices– From the government budget constraint, the real value ofgovernment debt has to equal the expected discounted
sum of future primary surpluses:
B(t)/P(t) = E(t)PDV(r)[Future Primary Surpluses].
– Under AF, when the surplus falls or is expected to fall,
the PDV decreases;– As the nominal debt is a predetermined state variable,
the price level (P(t)) has to adjust.
– With flexible prices, this will be achieved by an
unexpected jump in the price level

Understanding the FTPL: Flexible prices– The basic economic mechanism is the wealth effect offiscal disturbances upon private expenditure. Lower
surpluses make households feel wealthier, and thus
leads them to demand goods and services in excess of
those the economy can supply, except insofar as prices
rise.
– With PM, price level determined by fiscal policy (FTPL);– With AM, monetary policy leans against the rise inprices, real interest rate burden increases, which lowers
the PDV, and which requires an even higher jump inprices. With AM, there may be no equilibrium orexplosive equilibria.

Understanding the FTPL: Flexible prices• Focus on AF/PM: what does an interest rate
tightening do?
– A rise in the interest rate is like a deficit shock, unlessinflation jumps up one for one, as it is the real interest
rate that matters: r=R-PI.
– With flexible prices, that is what will happen: Inflation will
jump up. Real debt is not affected and over time bothinflation and the interest rate will gradually fall back tosteady-state.
– !! MP tightening leads to immediate rise in inflation !!
“Stepping on a rake”

Understanding the FTPL: larger model• Larger model differs in a number of features: sticky
prices, habit formation, long-term debt,...
• Maintain PM/AF assumption - Fiscal shock.
• Intertemporal budget constraint becomes:V(t)B/P(t) = E(t)PDV(r(t))[Future Primary Surpluses– In the short run, prices are sticky, but :– The real interest rate falls; this will tend to increase thepresent discounted value of future surpluses;– The value of outstanding long-term debt fallsUnderstanding the FTPL: larger model

Understanding the FTPL: larger model• Monetary policy shock:– In the short run, the government budget constraint isalleviated by the fall in the value of long-term debt inresponse to the rise in long-term interest rate:– Intertemporal budget constraint:V(t)B/P(t) = E(t)PDV(r(t))[Future Primary Surpluses]

Understanding the FTPL: larger model“Delayed rake effect”

Some cheap shots• Calibration? Sensitivity?
• Would be good to go step by step to see how thevarious additional features matter for the impulse
responses?
– Under what conditions do you get an initial recession?
Does habit formation matter?

• How does the region of the AF/PM depend on on
the calibration?

Empirical evidence? Interest rate shock• The sticky-price model implies that prices first fall
and then rise following an interest rate contraction.
Similarly, inflation first drops and then rises above
steady-state.

Impulse responses to an interest rate shock• This is not what one finds in the empirical VAR
literature started by Sims (1980)!
• Struggle with the price puzzle: Prices first rise
before falling after a monetary policy tightening.

Sample period?

Impulse responses to an interest rate shock• If there has been a regime shift in the US from
AF/PM in the 1970s to AM/PF in the 1980/90s(Clarida, Gali and Gertler), then the impulse
responses may have changed. as the US moved
towards.
– Again, the evidence appears to show the opposite: For
example, Christiano, Eichenbaum and Evans (1999) findthat if anything the price puzzle is worse in the 1965-1979
period than in the later period.

Impulse responses to an interest rate shockEmpirical evidence: Fiscal shock• The FTPL has no problem generating aconsumption increase after a positive spending
shock:

Impulse responses to a fiscal shock• This is more problematic for the standard
RBC/New Keynesian models:– Typically, an increase in government spending generatesa negative wealth effect on consumption; this leads also
to a shift in labour supply and rising output– Gali, Lopez-Salido and Valles (2007) develop a New
Keynesian model with rule-of-thumb consumers toaccount for the positive consumption multiplier in the US
data. However, they fail to generate real interest rate
decrease in that model.
– The FTPL has no problem generating the real rate fall.

Regime changes?
• Perotti (2004)– Concludes that the effects of fiscal policy on GDP havefallen since early 1980s.
– In the first sample, private consumption increases, thereal interest rate falls or increases little.
– In the second sample period, effects on consumption arenegative, but the real interest rate increases.

Regime changes?

Normative analysis?
• The AF/PM does lead to a stable inflation
environment, but generates volatility in response
to fiscal shocks.
• What can we say about the desirability of such aregime?

Woodford’s (2000) recommendation• “As a practical proposal …, I shall suggest that aTaylor rule for monetary policy should beaccompanied by targets for the size of government
budget deficits.”• “Fiscal policy should be locally Ricardian, so that
fiscal expectations do not frustrate the central
bank’s use of a suitably “active” monetary policy
to stabilise the price level.”Benigno and Woodford (2006)• Derive targeting rules for monetary and fiscal
authorities in a New Keynesian model with
distortionary taxes.
– Changes in taxes should be chosen to serve the same
objectives as those emphasized in the literature on
monetary stabilisation policy: stabilisation of inflationand of a properly defined output gap, which takes into
account tax distortions.
• CB: flexible inflation targeting rule– Similar to NK models with distortionary taxes• FA: set optimal level of government borrowing as a function of
the fiscal authority’s projections of the exogenous determinantsof fiscal stress and of future real activity.

Monetary/fiscal policy framework in EMU• Monetary policy delegated to an independent
central bank (ECB) focused on maintaining pricestability:– Definition: Annual HICP inflation below, but close to 2percent.

• Constraints on fiscal policy (debt and deficit) aimed
at avoiding spending and deficit biases, which may
be worse in a monetary union with mostly national
fiscal authorities.

The Treaty and the Stability and Growth Pact
Building blocks of the EMU fiscal framework are laid
down in the Treaty• Art 101: Prohibits monetary financing by the ESCB• Art 103: No-bail-out clause – European institutions andMember States can not be liable for or assume otherMS’s financial obligations• Art 104: Excessive deficit procedure (EDP)• Protocol on EDP: 3% and 60% reference values
But Treaty needed to be made operational

The Stability and Growth Pact (SGP)• “Preventive arm”:– Stability and convergence programmes– “close to balance or in surplus” requirement• “Corrective arm” clarified and strengthened the EDP:
– 3% reference value: hard ceiling– Clear timetable; “exceptional circumstances”; sanctions• European Council resolution (solemn declaration)– Political commitment

What happened?
What happened and what should have happened:
the actual euro area deficit versus the program m e vintages% of GDP

1.0
0.0
-1.0

SGP enteredinto force-2.0-3.0
SGP reform-4.0-5.01995

1997

1999

2001

2003

2005

2007

2009

ActualSPs 98/99

SPs 99/00

SPs 00/01

SPs 01/02

SPs 02/03

SPs 03/04

SPs 04/05

SPs 05/06

SPs 06/07

The revised Pact: what has changed?
• Preventive arm:
– Differentiated Medium Term Objectives (MTOs);– Adjustment path towards MTO (benchmark: 0.5%
cyclically adjusted);– Taking into account structural reforms (pension reforms).

• Corrective arm:
– Revised definition of “severe economic downturn”– Listing of “other relevant factors”– Extension of deadlines and repeated recommendations
and notices