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THE PRICE LEVEL: INTRODUCTION 3

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It is more difficult than one might think to develop restrictions on the data that allow us to distinguish between the two regimes. For example, Figure 1 suggests that there has been a positive relationship between primary surpluses and government liabilities in the United States over the last forty five years. One might take this as prima facie evidence of a fiscal reaction function that could have led to a MD regime. However, we will show that there should also be a positive relationship between surpluses and liabilities in a FD regime, with the direction of causality going the other way. We have to look further than simple correlations between surpluses and debt to find our testable restrictions.
Bohn (1995) argues that the surplus to GNP ratio responds positively to the debt to GNP ratio in the post war period (1948-1989) once temporary government spending and cyclical effects have been accounted for; if his use of these extra variables properly identifies the relationship he estimates as a policy reaction function, then his work offers evidence in favor of a MD regime. More generally, however, we may have to look further than fiscal reaction functions, even if they are well identified. To see why, suppose a fiscal retrenchment is expected to occur at some time well into the future. As we will show, such an expectation can result in a MD regime, but there may not be any evidence of it in our limited sample period. Developing an appropriate set of testable restrictions is one of the main contributions of the paper.

The rest of the paper is organized as follows. In section II, we review the new theory of price determination and illustrate the breadth of the class of fiscal policies that result in a MD regime. We also develop the restrictions that will allow us to distinguish between MD and FD regimes. Readers who are well acquainted with the theory may wish to skip to the last part of this section, where the restrictions are developed. In section III, we test these restrictions, and in section IV we discuss caveats about our conclusions and directions for future work.