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What Should Central Banks Peg? Arguments for Fiscal Goals

By Renato Lembe Agurto

Unfortunately for its critics, Macroeconomics is yet to die. However, it is true that its foundations were profoundly shaken by the financial crisis: mainstream economists were unable to predict the bust and were able to partially counteract its recessive effects only by adopting unprecedented policies (Chen et al., 2019).

Furthermore, the New-Keynesian theoretical model has failed to explain inflation linear stability as interest rates fell virtually to zero. According to the traditional understanding of the topic (McCallum, 1980), in circumstances where rates are unable to react more than proportionally to inflation, indeterminacy should emerge and prices would vary randomly. In practice, this has not occurred.

Thenceforth, heterodox approaches, such those of the Austrian School and of the Modern Monetary Theory, have become considerably popular among graduates, market experts and elected representatives. On the other hand, some economists have attempted to correct the mainstream theory without abandoning its methodological and fundamental premises. One of these economists is John Cochrane, fellow at the Hoover Institute.

In one of his recent papers, Cochrane (2017) tried to explain why inflation became low and flat at interest rates lower bound. If not anchored by a reactive monetary rule, prices should have soared with the money supply – but that was definitely not the case: money supply increased massively due to quantitative easing policies, while inflation levels have remained remarkably stable.

Building on financial pricing and Sims’ macroeconomic contributions (1994), Cochrane suggested an unusual, but reasonable anchor for prices: the public debt. Elaborating his own version of the Fiscal Theory of the Price Level (FTPL), he managed to convincingly conciliate New-Keynesian monetary policy with inflation linear stability at the lower bound.

Let us understand the core of FTPL (Cristiano & Fitzgerald, 2000). The first step is to assume, quite obviously, that central bankers manipulate interest rates mainly through open-market operations – buying and selling public bonds. Before exploring it further, let us remember a basic relationship: bond prices are inversely proportional to interest rates. For instance: assume a bond that costs US$ 990 and promises a reward of US$ 1,000 in one-year time. In this case, the bond’s interest rate is approximately 1% a year. If, for whatever reason, its price falls to US$ 980, its interest rate will increase to approximately 2% a year. Therefore, when bonds’ prices fall, interest rates increase proportionally.

In order to manipulate the latter, monetary authorities supply and demand public bonds, influencing their prices in the market. If central bankers aim at diminishing rates, they buy bonds, and vice-versa.

The second premise is equally obvious: private agents perceive bonds as a type of financial assets, just like stocks, debentures, etc. Thus, they make buying and selling decisions according to financial pricing methods. The chief method is to compare bond’s current price with the sum of their expected present-value-adjusted cash inflows. If, for whatever reason, the former surpasses the latter, bonds are sold, forcing prices down so to reestablish the equality.

As it follows from these two premises, bond’s prices are determined by authorities’ open-market operations and by expected primary fiscal surpluses (revenues less expenditure, excluding interest spending), which assure future cash inflows in benefit of holders. This second factor prevails over the first, as authorities rely on private cooperation to effectively manipulate bond’s prices and, consequently, interest rates.

As private agents choose between bonds and “real” assets to allocate their money, FTPL advocators conclude that fiscal policy alone – mainly through fiscal surpluses management – influences aggregate consumption and investment and, thus, inflation itself. Central bankers, therefore, must necessarily coordinate their efforts with those of the Treasury and the Parliament in order to achieve their monetary goals.

According to Cochrane (2017), FTPL model is able to explain both the mainstream Taylor Rule’s mechanism and inflation linear stability at the lower bound, if one adds the premise of price level rigidity.

Let us, then, imagine centrals bankers pursuing diminished interest rates so to stimulate the economy: their first measure would be to buy bonds, so to increase their prices immediately, while expected primary surpluses would remain unchanged. As a result, private agents would reallocate their money in “real” assets, increasing aggregate demand, production and inflation. That is the core of the Taylor Rule.

Nevertheless, as time goes by, the original monetary stimulus would cause expected primary surpluses to grow, as tax revenues are positively correlated with economic activity. Therefore, in a second moment, authorities’ original buying decision would cause private agents to buy bonds, too. This means that, in the long run, interest rates and inflation are positively associated and tend to converge. This may explain why both variables have been flat at similar levels since 2008. Besides, fiscal policy may have served as an anchor for prices, precluding random variations. If this FTPL version is true, most of mainstreams’ model is saved thanks to the remarkable efforts of Cochrane.

Naturally, this new macroeconomic framework must be subjected to further empirical and operational studies before being officially adopted. Moreover, technical coordination of fiscal and monetary policies, though desirable in FTPL’s point of view, may represent an unacceptable limitation to representatives’ power to determine the public budget, which represents a founding political ritual of modern democracies.

On the other hand, one vital pillar of FTPL, which dates back to Henry Simon’s times, Milton Friedman’s friend and mentor, must be cautiously meditated by all modern economists: “Ultimate control over the value of money lies in fiscal practices – in the spending, taxing, and borrowing operations of the central government” (apud Friedman, 1969, p. 87).


Chen, Q., et al. (2015). Financial Crisis, US Unconventional Monetary Policy and International Spillovers. IMF Working Paper, 15(81), 1-31.

Cochrane, J. (2017). Michelson-Morley, Fisher, and Occam: The Radical Implications of Stable Quiet Inflation at the Zero Bound. National Bureau of Economic Research Macroeconomics Annual, 32, 113-226.

Cristiano, L. & Fitzgerald, T. (2000). Understanding the Fiscal Theory of the Price Level. Economic Review, 36(2), 1-38.

Friedman, M. (1969). The Optimum Quantity of Money and Other Essays. Mamaroneck, USA: Macmillan.

McCallum, B. (1980). Price Leve Determinacy with an Interest Rate Policy Rule and Rational Expectations. National Bureau of Economic Research Working Papers, 559, 1-19.

Sims, C. (1994). A simple model for study of the determination of the price level and the interaction of monetary and fiscal policy. Economic Theory, 4, 381-399.

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