Working paper

Fiscal Requirements for Price Stability When Households are Not Ricardian

Published on the 23rd of December 2024
Authors : Stéphane Dupraz , Anna Rogantini Picco

Working Paper Series no. 981. Are restrictions on fiscal policy necessary for monetary policy to be able to deliver price stability? When households are Ricardian, the Fiscal Theory of the Price Level asserts that the government's intertemporal budget constraint must hold for on-target inflation. We show that when households are not Ricardian, fiscal requirements still exist but are very different. (1) Intertemporal budget constraints no longer impose any significant requirement on fiscal policy for price stability. A requirement derived from intertemporal budget constraints still exists, but it does not correspond to the one of the government and imposes much looser requirements on fiscal policy than in the Ricardian case. (2) Yet a second requirement exists, specific to non-Ricardian households: Public debt must remain below a threshold. Above it, its wealth effect on aggregate spending can no longer be counter-balanced by interest rate hikes, however large. This second requirement puts an upper bound on public debt regardless of future fiscal surpluses. Assessing risks of fiscal dominance is therefore very different when households are not Ricardian

Equilibrium Uniqueness

Image The diagram represents when there exists a unique bounded equilibrium (in green), no bounded equilibrium, or a multiplicity of equilibria (indeterminacy) as a function of the degree of responsiveness of monetary policy to inflation Фπ and the degree of responsiveness of fiscal policy to public debt Ψb. The left panel represents the case of Ricardian households, with a strict distinction between a regime of fiscal dominance and a regime of monetary dominance. The right panel represents the case of non-Ricard Thématique Inflation Catégorie Working paper
Note: The diagram represents when there exists a unique bounded equilibrium (in green), no bounded equilibrium, or a multiplicity of equilibria (indeterminacy) as a function of the degree of responsiveness of monetary policy to inflation Фπ and the degree of responsiveness of fiscal policy to public debt Ψb. The left panel represents the case of Ricardian households, with a strict distinction between a regime of fiscal dominance and a regime of monetary dominance. The right panel represents the case of non-Ricardian households, with no such strict distinction.

Give the central bank a clear mandate of price stability. Grant it full independence from the government. And appoint at its head a steadfast governor who will not let anything but its mandate influence its policy. Does the central bank then have all it needs to deliver price stability? Or must requirements on the government's fiscal policy also be imposed? The question is a cornerstone of monetary-fiscal interactions, determining whether monetary policy has the power to insulate inflation from imprudent fiscal decisions, or is ultimately dependent on a well-behaved fiscal authority.

The existence of fiscal requirements for price stability is at the root of the convergence criteria of the Stability and Growth Pact in the euro area, but they have no consensual basis in economic theory. Today, the main rationale for fiscal requirements is the Fiscal Theory of the Price Level (FTPL) (Leeper 1991, Sims 1994, Woodford 2001, Cochrane 2001). Yet the FTPL remains controversial to this day. While early skepticism of the FTPL focused on its strong reliance on equilibrium selection, recent skepticism points to its strong reliance on the assumption of Ricardian households. As the Heterogeneous Agents New Keynesian (HANK) literature has become an appealing alternative to the Ricardian representative household, the robustness of the FTPL has been put into question.
We show that when households are not Ricardian, fiscal requirements for price stability still exist, but take a very different form. Under Ricardian households, the FTPL asserts that if the government does not satisfy its intertemporal budget constraint in the absence of above-target inflation, then the central bank cannot deliver price stability. Inflation must set in to dilute the real value of public debt until it matches the level of real future primary surpluses.

In the paper, we move from Ricardian to non-Ricardian households. Following the tradition of the FTPL, we first consider what requirements arise from intertemporal budget constraints. We show that when households are not Ricardian, households' intertemporal budget constraints impose only very weak requirement. In particular, if, from any current level of public debt, the government plans on never raising any tax to repay it, this violates no household's intertemporal budget constraint.

While intertemporal budget constraints no longer pose any significant constraint, we show that a new requirement on fiscal policy for price stability arises. When households are not Ricardian, higher public debt increases aggregate demand through a wealth effect, putting upward pressure on inflation. This in itself poses no constraint on the ability of the central bank to maintain price stability. It can counter the inflationary effect of higher debt with higher interest rates, just like it can counter any other demand shock with higher interest rates, retaining the ultimate control over inflation.
We show, however, that there exists a debt limit beyond which no interest rate, even very high, can counter-balance the effect of higher debt on aggregate demand and bring it back in line with aggregate supply. We therefore recover a fiscal requirement for price stability when households are not Ricardian. But it is very different from the requirement of the FTPL obtained when households are Ricardian. 
We conclude by analyzing how the central bank can implement price stability once these fiscal requirements are satisfied. In doing so we reconsider Leeper (1991)’s local version of the FTPL in the case of non-Ricardian households. We show that when the central bank follows a standard Taylor rule that responds to inflation, fiscal shocks always affect inflation, however strong the response of monetary policy to inflation. It it no longer possible to distinguish between a monetary regime and a fiscal regime (see Figure below). Yet, we show that monetary policy can implement price stability if it responds to both inflation and the level of public debt. Inflation is then insulated from fiscal shocks. 

 

Keywords: De-Anchoring; Taylor Principle; Bounded Rationality
JEL classification: E52, E31, E43

 

Updated on the 24th of December 2024