. thus, once we allow for the possibility of default by the fa, a sufficiently tough cb can have considerable control over the price level. of course, i ’ ve been arguing through examples. it would be more interesting to deliver a fuller characterization of the term “ sufficiently tough ” – but i ’ m not going to attempt to do so. instead, in what follows, i ’ ll discuss some aspects of the cb ’ s response to a particularly critical situation. suppose the fa owes $ 10 billion on a given friday. it plans to repay that loan by auctioning new debt on the preceding monday. however, when it auctions off the new debt, it finds that it can only raise $ 5 billion. the fa is now in danger of defaulting on its friday obligation of $ 10 billion. it is at this stage that the level of commitment of the cb to its chosen inflation path will be severely tested. the fa will ask the cb to take some action that will allow the fa to raise an additional $ 5 billion on wednesday. there are many possible actions. the fa might ask the cb to intervene by setting a floor on the price of debt in the wednesday auction. but there are less overt approaches. for example, the cb can commit to a price peg for the fa ’ s debt in the secondary market for that debt. in any event, if the cb does intervene in some way to ensure the fa ’ s solvency, the cb no longer can be said to have independent control over the price level. if the cb ’ s intervention was largely unanticipated by markets, expected inflation will rise after the cb ’ s intervention. then, incipient fiscal insolvency has triggered inflationary pressures. of course, markets may well have already assigned a positive probability to the possibility that the cb might intervene in this kind of scenario. if so, then past inflation was already influenced by the markets ’ expectations of this fiscal policy scenario. as modeled, for example, by eaton and gersovitz ( 1987 ). see kocherlakota ( 2011 ). here, i ’ m assuming that the cb is exchanging reserves and fa securities so as to control the path of a shortterm nominally risk - free interest rate. this nominally risk - free interest rate may not be the same as the interest rate on fa debt. atkeson, chari and kehoe ( 2010 ) and cochrane ( 2011 ) argue ( convincingly to my mind )

my remarks today, i will relax this assumption. once i do so, it will become clear that a sufficiently tough central bank does have the ability to control the price level, regardless of the behavior of the fiscal authority. 3 i will argue that its ability to do so hinges on the nature of its response to the possibility of default on the part of the fiscal authority. i will talk about some of the short - run versus long - run tensions involved in that response. throughout, i will refer to the central bank as cb and the fiscal authority as fa. i will refer to the currency as being dollars, but that should not be viewed as suggesting that i am talking about the united states – or australia. see cochrane ( 2005 ). the present - discounted - value formula for stock price evaluation is based on the assumption that the stock price does not have a bubble component. in the same way, the intertemporal government budget constraint relies on the assumption that the price of neither money nor bonds has a bubble component. this assumption is violated in a wide class of models of money. see bassetto ( 2008 ) for a related analysis. bis central bankers ’ speeches let me start by describing a simple cb policy : a commodity price peg. suppose the central bank holds x ounces of gold. it commits to being willing to buy and sell p dollars for each ounce of gold and has a monetary base of $ px. this policy successfully ties the price level to variations in the price of gold, regardless of the behavior of the fa. what impact does this policy have on the fa? now, when the fa borrows in dollars, it is essentially borrowing in a real commodity : gold. all of the fa ’ s debt is essentially indexed to the price of gold, and it is certainly conceivable that various shocks could lead the fa to default on those obligations. 4 of course, as i have argued elsewhere, this simple policy is generally viewed as suboptimal by macroeconomists. 5 in contrast, suppose that the cb follows an aggressive taylor rule when determining the path of the short - term interest rate. 6 that policy pins down an inflation path in the usual way, regardless of the fa ’ s fiscal plans. 7 however, given that inflation path, the fa ’ s nominal debt is now actually real. this means that if the fa is faced with an unexpected decline in its current and expected future real surpluses, it will be forced to default