Testing the Fiscal Theory of Price Level in Case of Pakistan

There are two competing views of the interaction between monetary and fiscal policy and their effects on price stability for policy-maker’s point of view. In the classical view, in Ricardian regimes it is the demand for liquidity and its evolution over time that determines prices. In such a regime fiscal policy is passive, which implies that government bonds are not net wealth [Barro (1974)], and monetary policy works through the interest rate or another instrument to determine prices. In the opposite view which is more recent, a non-Ricardian regime will prevail whenever fiscal policy becomes active1 and does not accommodate or adjust primary surpluses to guarantee fiscal solvency. As a result, the Ricardian equivalence do not hold, and the increase in nominal public debt to finance persistent budget deficits is perceived by private agents as an increase in nominal wealth. In fiscal dominant regime the government’s fiscal policy becomes sustainable through debt deflation that is an increase in prices that wash away the real value of public debt and in turn the real value of financial wealth until demand equals supply and a new equilibrium is reached. In this regime prices are determined by fiscal policy, and inflation becomes a fiscal phenomenon. If, on the other hand, primary surpluses follow an arbitrary process, then the equilibrium path of prices is determined by the requirement known as fiscal solvency; that is, the price level has to jump to satisfy a present value budget constraint called non-Ricardian regime. The basic distinction between the two regimes is that in non-Ricardian regime fiscal policy plays the role where as in Ricardian regime monetary policy provides stability in prices. In FTPL, the results of fiscal and monetary policies depend on which policy has dominant characteristics. The consequences of policies differ depending on the active and passive characteristics of the policy and depending on the characteristics of the following policy. If the policy mix is such that monetary policy is active and fiscal policy is passive, fiscal policy accommodates monetary policies; these policies are called dominant monetary policy by Sargent and Wallace (1981) and Ricardian regime by Woodford (1994, 1995).