Testing the Fiscal Theory of Price Level in Case of Pakistan

Abstract

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).

Public debt and inflation nexus in Nigeria: An ARDL bounds test approach

“…There are, however, two competing views on the interaction between monetary and fiscal policies and their effects on price stability. The classical view of Ricardians argues that it is the demand for liquidity and its progress over time that defines the path of prices (Attiya et al, 2008). In such rule, fiscal policy is passive, suggesting that government bonds are not net wealth, and monetary policy works through interest rates to determine prices.…”

“…In such rule, fiscal policy is passive, suggesting that government bonds are not net wealth, and monetary policy works through interest rates to determine prices. The Ricardian view assumes that price levels are mainly determined by money supply in the long run (Attiya et al, 2008). The Ricardian equivalence, according to Barro (1974Barro ( , 1989, is based on a monetarist view on inflation that government deficit or public debt does not have a significant impact in the determination of price level, implying that government bonds are not net wealth.…”

Dynamic Effects of Changes in Government Spending in Pakistan’s Economy.

“…A feedback from the level of debt ratio to taxes and government spending is necessary for stability of the debt, unless the rate of growth of the economy is exactly equal to the average cost of financing the debt. Such a feedback is a feature of the Pakistani fiscal data as is revealed by a positive correlation between the government surplus-to-GDP ratio and the government debt-to-GDP ratio [Javid, Arif, and Sattar (2008)]. The interest rates, an important variable in the transmission of fiscal shocks, depend on future expected monetary policy and on the risk premium: both may be affected by the debt dynamics.…”

Public debt, inflation, and the Fiscal Theory of Price Level in emerging markets: the case of Paraguay

“…Instead, their findings suggested that a non-Ricardian or FD regime was present in Turkey, mainly after the 1980s due to the increasing cost of debt and the financial liberalization. Javid, Arif, and Sattar (2008) implemented a VAR approach based on Canzoneri et al to analyse the FTPL assumptions in Pakistan for the period 1971-2007. They found mixed results: 1) liabilities decrease as a response to higher surplus; this is in line with a Ricardian (MD regime); 2) as predicted by the FTPL, the wealth effect of changes in nominal public debt seems to increase prices and therefore to drive inflation.…”

“…Similar non-Ricardian evidence was reported by Tanner and Ramos (2003) for Brazil and Bildirici and Ersin (2005) for Turkey. However, evaluating only the full sample might lead to misleading conclusions, as Javid, Arif, and Sattar (2008) suggested.…”