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Stepping on a Rake: the Fiscal Theory of Monetary Policy

John H. Cochrane

NBER Working Paper No. 22979
Issued in December 2016, Revised in October 2017
NBER Program(s):Asset Pricing, Economic Fluctuations and Growth, Monetary Economics

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.

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Document Object Identifier (DOI): 10.3386/w22979

Published: John H. Cochrane, 2017. "Stepping on a Rake: the Fiscal Theory of Monetary Policy," European Economic Review, .

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