Is the Price Level Determined by the Needs of Fiscal Solvency?
A new theory of price determination suggests that if primary surpluses are independent of the level of debt, the price level has to jump' to assure fiscal solvency. In this regime (which we call Fiscal Dominant), monetary policy has to work through seignorage to control the price level. If on the other hand primary surpluses are expected to respond to the level of debt in a way that assures fiscal solvency (a regime we call Money Dominant), then the price level is determined in more conventional ways. In this paper we develop testable restrictions that differentiate between the two regimes. Using post war data, we present what we think is overwhelming evidence that the United States is in a Money Dominant regime; even the post Reagan data (1980 to 1995) seem to support that contention.
Canzoneri, Matthew B., Robert E. Cumby and Behzad T. Diba. "Is The Price Level Determined By The Needs Of Fiscal Solvency?," American Economic Review, 2001, v91(5,Dec), 1221-1238. citation courtesy of