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The Fiscal Theory of the Price Level – Some Inferences Based on Literature Review
Date:11.23.2023 Author:Guo Kai - CF40 Institute

Abstract: The paper made a literature review and drew some inferences from the fiscal theory of the price level (FTPL), which may help us think about the impacts of the US high debt on inflation and asset prices and what it means for resolving China’s local government debt.

The central equation of the theory can be explained as "the government's present real debt needs to be equal to the net present value of the future government's real primary surplus". This leads to the fundamental conclusion and prediction that a decline in the government's surplus leads to an increase in the price level, i.e., inflation. The fiscal theory of the price level is not consistent with the belief that "inflation is a monetary phenomenon" and does not necessarily lead to inflation through the mechanism of fiscal overdrafts from the monetary authority or mint taxes, but is essentially a theory of asset pricing.

Under specific assumption, there are three intuitive inferences from the fiscal theory of the price level: 1) unexpected increases in government expenditures lead to higher prices, i.e., inflation; 2) given the same increase in government expenditures, the larger the government's existing debt, the less prices will rise; and 3) given the same increase in

government expenditures, the longer the duration of the government's existing debt, the less prices will rise. Comparisons of OECD data by Robert Barro of Harvard University and Francesco Bianchi of Johns Hopkins University, as well as Barro's calculations of U.S. data, have tested these inferences.

Lastly, based on the framework of fiscal theory of the price level, the paper also briefly deduced the implications of China’s local government debt for supply of base money, inflation, trend of bond interest rates, exchange rate changes, etc.