In The Fiscal Theory of the Price Level, John H. Cochrane examines fiscal theory, the relationship between fiscal and monetary policy, and the impact of fiscal analysis on the study of inflation. Dividing the book into five parts, the author provides a range of simple and complex fiscal models, offering rigorous explanations. His thoughtful pairing of equations and text thoroughly introduces the mechanisms of fiscal theory and its applications in historical and institutional analysis. Cochrane describes how fiscal theory developed and how future researchers can explore and refine it. He highlights the importance of applied fiscal models and encourages others to continue analyzing how these models can describe the real world.
Cochrane begins part I of the book by introducing key fiscal theory dynamics among government debt, government surpluses, and the price level. According to the author, fiscal theory posits that changes in the price level occur such that government debt is equivalent to the present value of future government surpluses. The author emphasizes that even in periods with lower surpluses, an expectation exists that future surpluses will allow the repayment of debt. Cochrane then describes the value of studying fiscal theory in conjunction with monetary policy. He examines the impact of interest-rate targets on inflation and models responses to fiscal and monetary shocks. By analyzing how fiscal and monetary policy can contribute to expected and unexpected inflation, he illustrates the effect of policy on the price level. He presents the role of monetary policy in setting government debt, as well as the role of fiscal policy in determining surpluses. The comprehensive overview of fiscal theory provided in part I creates a strong foundation for understanding the author’s deeper analysis in later chapters.
In part II of the book, Cochrane discusses types of assets, price-level stability, and the role of economic institutions in maintaining that stability. The influence of rapid technological advancements on money inspires his evaluation of various fiscal commitments. The author discusses exchange-rate pegs and the gold standard as active fiscal policies to which the government commits in order to maintain price-level stability. In the case of an exchange-rate peg, the government exchanges its currency for a foreign currency at a fixed rate. Similarly, under a gold standard, the government exchanges its currency for gold at a fixed rate. Cochrane acknowledges the tradeoffs associated with implementing pegs and standards, including fluctuations in relative prices that can lead to inflation or deflation. His explorations of alternative targets and standards, such as a spread target or even a standard based on a consumer price index, enhance the discussion of potential policies. However, Cochrane’s main focus is on assessing the effectiveness of interest-rate targets in maintaining a stable price level. He describes the role of a central bank in setting interest rates relative to an inflation target and considers how varying levels of independence between a country’s central bank and Treasury can influence inflation policies. Above all, in discussing ways to achieve price-level stability, Cochrane suggests that the government should demonstrate its commitment to price stability by managing its debt and surpluses.
In part III, Cochrane illuminates the differences between monetary and fiscal theory. He tests the validity of monetarist concepts over time and compares their relevance with that of concepts in fiscal theory. This discussion reviews and contrasts the underpinnings of each theory (related to the efficacy of interest-rate pegs), the significance of the division between money and bonds, and the impacts of open-market operations. Cochrane emphasizes the influence of the quantity of government debt on the price level in fiscal theory. His fiscal models allow for adapting the definition of money to new financial technologies. By accommodating a changing definition of money, fiscal theory exhibits considerable flexibility in describing fiscal events over time. Cochrane then focuses on hyperinflation to better understand the factors contributing to economic instability. Although he concurs that printing money contributes to inflation, he calls for a deeper examination of the fiscal policies surrounding hyperinflation, seeking to understand how this phenomenon varies in length and intensity. Cochrane suggests further study of inflationary and hyperinflationary periods, especially in various countries throughout the world.
In part IV, Cochrane explores observational equivalence, equilibrium selection policy, and the zero bound. He acknowledges how monetarist, new-Keynesian, and fiscal theories can apply different reasoning to describe the same event, and he highlights the importance of specifying reasonable assumptions to distinguish between the theories. Cochrane conveys that fiscal theory offers solutions to certain issues that arise in monetary theory and new Keynesianism, including multiple equilibria and the zero bound. The author demonstrates that fiscal theory can determine equilibrium and explain historical periods of low inflation, such as during the 2010s. He equally applies fiscal theory to the rise of inflation in 2021 during the COVID-19 pandemic, when government debt increased. The ability of fiscal theory to describe inflation in a way consistent with real observations points to the theory’s validity and useful contributions to the economic literature. Cochrane also acknowledges some arguments against fiscal theory, but he corrects common misconceptions underlying those arguments. He believes fiscal theory is worthy of further study to better understand the economic outcomes of fiscal policy.
In part V, Cochrane reflects on the existing body of research on fiscal theory and looks forward to future studies. He recognizes the contributions of other economists to fiscal theory and considers methods to further evaluate applications of the theory. One such method involves incorporating fiscal theory into new-Keynesian models and using dynamic stochastic general equilibrium modeling in data analysis. Cochrane also encourages future researchers to study inflation across various countries and periods. Besides encouraging analyses of Japan and Europe, he singles out the fiscal and monetary history of Latin America as a meaningful subject for future study.
The Fiscal Theory of the Price Level is a captivating read that prompts a deeper reflection on the influence of fiscal policy. Cochrane delineates foundational and advanced elements of fiscal theory and relates those elements to inflation. He demonstrates not only price-level determination with fiscal theory but also the stability of the price level in fiscal theory. He illustrates the value of incorporating fiscal theory into existing models to enhance our understanding of price-level changes. He supports his assertions with equations, models, and data visualizations. His thorough analysis of fiscal theory alongside monetarism and new Keynesianism provides an exciting collection of insights that traces the history of inflation to emerging fiscal research.
United States Department of Labor
