Aurora Borealis
1 November 2013 CFA Institute Journal Review

Paper Money (Digest Summary)

  1. Yaw Mante

Monetary policy actions have fiscal implications. For monetary policy to be effective, it needs to be linked to fiscal policy. The fiscal theory of the price level integrates fiscal and monetary policy interactions and is better at explaining the price level than conventional macro models, which have a strong relationship between the price level and the quantity of “money” and a “money multiplier.”

What’s Inside?

The author shares insights from the literature on the fiscal theory of the price level (FTPL) to demonstrate how it explains fiscal and monetary interactions. The key insight is that central bank balance sheets are important because they connect monetary and fiscal policy. This insight challenges the views that central bank balance sheets are just accounting entries, that they are of little consequence, and that only the government’s balance sheet matters. Those positions do not hold when a central bank wants to control the price level and when the fiscal and monetary policies are not set jointly.

How Is This Research Useful to Practitioners?

The author uses the example of a central bank with negative net worth that tries to control inflation without fiscal support. Such a central bank may find its conventional tools ineffective. If the bank undertakes open market operations to reduce the amount of reserves and currency, it will have to sell assets that it does not have. Raising interest rates on reserves also puts the central bank on an unsustainable path because it would need to sell assets to finance interest on reserves. But if the Treasury stands ready to provide additional assets in the form of interest-bearing securities whenever necessary, then the central bank can successfully control the price level.

Another relevant point is that paper money requires fiscal backing. The author argues this point by explaining that if there is no fiscal backing for a constrained central bank, then paper money is expected to collapse. Without fiscal backing, and in the event of capital losses, a constrained central bank would have to allow high inflation to try to repair its balance sheet, thus limiting its price-targeting abilities.

Finally, the author outlines the differences between nominal debt and real debt and highlights the challenges faced by countries in the European Monetary Union. He argues that although the value of both nominal and real debt should be equivalent to the discounted present value of future primary surpluses, nominal debt, given the impact of inflation on nominal rates, acts as a cushion in the event that those primary surpluses fall below a government’s predetermined real debt service commitment. This feature makes nominal debt very important to a lender of last resort because it is almost non-defaultable.

The article is relevant to policymakers. It gives contemporary fiscal and monetary authorities a good explanation of the policy issues they are facing; it is especially relevant to the ongoing discussions about the European Monetary Union and the fiscal implications of European Central Bank policies.

Fixed-income securities analysts, especially those focusing on government securities, will find the proposed framework useful for evaluating the impact of policy actions. Equity analysts who take a macro view will find this article useful as well.

How Did the Author Conduct This Research?

The author reviews a number of articles that collectively develop and set out the FTPL. This body of literature also includes his research articles. In addition, he provides a detailed review of a number of models that provide the basis for the insights shared.

Samuelson’s pure consumption loan model with storage is included, which shows that without tax backing for debt or money, the price level is indeterminate. The author also discusses an adjusted Taylor rule model (with fiscal backup) based on Leeper’s (Journal of Monetary Economics 1991) original framework, in which he concluded that fiscal backing is important for stable prices. But if financial markets are aware of the backing, the size of the backing can be quite small. Finally, he reviews a number of other models to explore the impact of inflation in cushioning fiscal shocks.

Abstractor’s Viewpoint

The author successfully argues that fiscal and monetary policies are inextricably linked. The insights from the FTPL that he shares provide convincing explanations of current fiscal and monetary policy issues, especially the currency challenges facing the EMU and the phenomenon of low inflation in an environment of growing central bank balance sheets. He also lays out clear policy action alternatives for dealing with such identified issues.

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