Financial innovation challenges the foundations of monetary theory, and standard monetary theory has not been very successful at describing the history of U.S. inflation. Motivated by these observations, I ask: Can we understand the history of U.S. inflation using a framework that ignores monetary frictions? The fiscal theory of the price level allows us to think about price level determination with no monetary frictions. The price level adjusts to equilibrate the real value of nominal government debt with the present value of surpluses. I describe the theory, and I argue that it is a return to pre-quantity theoretic ideas in which money is valued via a commodity standard or because the government accepts it to pay taxes. Both sources of value are immune to financial innovation and the presence or absence of monetary frictions. I then interpret the history of U.S. inflation with a fiscal-theory, frictionless view. I show how the fiscal theory can accommodate the stylized fact that deficits and inflation seem to be negatively, not positively correlated. I verify its prediction that open market operations do not affect inflation. I show how debt policy has already smoothed inflation a great deal.
*Published: This paper was subsequently published as A Frictionless View of U.S. Inflation, John H. Cochrane, in NBER book NBER Macroeconomics Annual 1998, volume 13 (1999)
NBER Macroeconomics Annual (1998), Cambridge: MIT Press, pp. 323-384.
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