Stepping on a Rake: The Fiscal Theory of Monetary Policy

57 Pages Posted: 27 Dec 2016 Last revised: 16 Apr 2023

See all articles by John H. Cochrane

John H. Cochrane

Hoover Institution; National Bureau of Economic Research (NBER)

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Date Written: December 2016

Abstract

The fiscal theory of the price level can describe monetary policy. Governments can set interest rate targets and thereby affect inflation, with no change in fiscal surpluses. The same basic mechanism describes interest rate targets, forward guidance, open market operations, and quantitative easing. It does not require any monetary, pricing, or other frictions. In the presence of long-term debt, higher interest rates lead to temporarily lower inflation, a challenging sign. I derive and replicate the results of the Sims (2011) “stepping on a rake” model, which first produced this negative sign, and produces realistic impulse-response functions. I show that Sims' result is robust to many model features, but essentially requires long-term debt.

Suggested Citation

Cochrane, John H., Stepping on a Rake: The Fiscal Theory of Monetary Policy (December 2016). NBER Working Paper No. w22979, Available at SSRN: https://ssrn.com/abstract=2890083

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