Inflation and the Fiscal Theory of the Price Level

It generally increases when prices go down and drops when prices rise. This means that one unit of currency in 1980 probably bought more goods and services than it does today. A price level is the average of the current prices of the entire range of goods and services produced in the economy.

  1. Traders often sell securities when they reach a certain price level, referred to as exit and entry points.
  2. In addition, the future paths of interest rates matter, too, as they provide the discounting in the present value calculations.
  3. According to estimates by the Committee for a Responsible Federal Budget, it would also wipe out any presumed savings under the Inflation Reduction Act.
  4. Another form of this bias arises because the government data collectors do not collect price data on weekends and holidays, when many stores run sales.

In contrast with other monetary theories, it may not be well known even among economists, although it has prominent exponents such as Christopher Sims (winner of the Nobel prize in economics), Michael Woodford and John Cochrane. However, the FTPL is often seen as a quite obscure economic theory without much interest to economists and policymakers. Economists differ on the degree to which these biases result in inaccuracies in recording price-level changes.

Purchasing power refers to how much of an item a unit of money can buy. The link between aggregate demand and general price levels is not necessarily clear or direct. However, in the most general sense (and under ceteris swing trading patterns paribus conditions), an increase in aggregate demand corresponds with an increase in the price level. This idea is captured by the concept of an intertemporal GBC (IGBC), which is the “present-value” version of the GBC.

According to this compilation, the Boston Red Sox was the most expensive team to watch in 2011; the Arizona Diamondbacks was the cheapest. The table shows the cost of the fan price index market basket for 2011. Just as inflation reduces the value of money, it reduces the value of future claims on money.

2 Price-Level Changes

Instead, it is commonly expected that Congress is tasked with being the guardian of U.S. fiscal solvency and debt stability. However, since such shopping has increased in recent years, it must be that for their customers, the reduction in prices has been more valuable to them than loss of service. Another form of this bias arises because the government data collectors do not collect price data on weekends and holidays, when many stores run sales. A third price index bias, the quality-change bias, comes from improvements in the quality of goods and services. Suppose, for example, that Ford introduces a new car with better safety features and a smoother ride than its previous model.

Are we missing a good definition for price level? Don’t keep it to yourself…

The importance in consumer budgets of the higher chicken price is thus overstated, while the importance of the lower beef price is understated. More generally, a fixed market basket will overstate the importance of items that rise in price and understate the importance of items that fall in price. Price levels are one of the most watched economic indicators in the world. Economists widely believe that prices should stay relatively stable year to year so that they don’t cause undue inflation.


Suppose the old model cost $20,000 and the new model costs $24,000, a 20% increase in price. Should economists at the Bureau of Labor Statistics (BLS) simply record the new model as being 20% more expensive than the old one? To the extent that such adjustments understate quality change, they overstate any increase in the price level.

For this reason, the real price level, which compares the prices of goods and services against the purchasing power of money, is particularly useful. Purchasing power goes down when prices rise because a single unit of currency can’t acquire the same amount as it once could. The converse is true when prices go down; purchasing power increases.

In contrast, when deflation occurs and prices drop too rapidly, the central bank can make monetary policy less tight, thus increasing the supply along with aggregate demand. The movement in prices is used as a reference for inflation and deflation, or the rise and fall of prices in the economy. If the prices of goods and services rise too quickly—when an economy experiences inflation—a central bank can step in and tighten its monetary policy and raise interest rates. This, in turn, decreases the amount of money in the system, thereby decreasing aggregate demand.

This would increase upward pressure on prices which would lower real interest rates and stimulate aggregate demand. The current price level therefore depends on the evolution of current and future fiscal variables. For instance, higher federal infrastructure spending today needs to be balanced by higher future tax revenue via tax hikes. If it’s not, there would be an impact on the residual variable, namely the price level. The FTPL then simply postulates that the price level is determined by and moves around based on the fiscal choices that the government makes.

As prices rise (inflation) or fall (deflation), consumer demand for goods is also affected, which leads to changes in broad production measures such as gross domestic product (GDP). In simpler terms, price level is the cost of a good or service in the economy, expressed in small ranges. Price levels allow economists to monitor changes in prices over a period of time. They are a crucial indicator in economics as they indicate  consumers spending power. Price-level targeting is, theoretically, more effective than inflation targeting because the target is more precise.

The fiscal impact would be drawn out over several years because of the impact of the missing loan repayments and other provisions in the debt forgiveness that alters income-based repayment plans. The Biden administration announced that it would “cancel” up to $10,000 in federal student loan debt (or $20,000 for some borrowers), subject to certain income limits. Although details remain scarce at this point, the debt forgiveness can be considered as an expense of the federal government. The debt cancellation and the subsequent reduction in loan payments is a reduction in tax revenue. The GBC tracks the evolution of debt issued by the federal government as a function of its revenue and its expenditure.

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