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THE PRICE LEVEL: INTRODUCTION 2

Consider next the policy issues that are at stake. The reduced form for the price level depends in an important way on which regime is in place. In a FD regime, monetary policy has to work through seignorage and the government’s budget constraint to control the price level; in a MD regime, monetary policy works through the familiar channels of aggregate demand management. Canzoneri and Diba’s (1996) numerical calculations suggest that the central banks of most OECD countries would lose control of their price levels in a FD regime, because seignorage is such a small component of total revenue. It is probably not reasonable to hold a central bank accountable for price stability in a FD regime, and this is one interpretation of the concern central banks have about the constraints placed upon them by loose fiscal policies. If this interpretation of their concern is justified, then policy simulations should be based upon the assumption of a FD regime, which is not the usual practice.

All of this suggests that the modeler’s choice of regime does not fall under the heading of “innocent assumptions”. The choice should not be made lightly. But which assumption is right? In this paper, we approach the question in two ways. The proponents of the new theory of price determination focus much of their attention on FD regimes. This is understandable since FD regimes are the new element here, and they yield unconventional results for price determination and monetary policy. MD regimes embody the conventional macroeconomic wisdom. This focus can however give the (perhaps unintended) impression that FD regimes are somehow the natural choice to make, and that MD regimes are a very special case. So, the first thing we do is present the theory in a way that dispels this impression. We do this by showing that a wide class of fiscal policy rules leads to MD regimes. These rules can stringent, or they can be very lax: there is considerable latitude for countercyclical policy and/or political noise. After establishing the ex-ante plausibility of MD regimes, we go on to test the hypothesis that the United States has been in a FD regime. Using post war data, we try to distinguish between MD and FD regimes empirically.