THE PRICE LEVEL: INTRODUCTION
Woodford (1994, 1995, 1996) and Sims (1994, 1995) have recently emphasized the role of the government budget constraint in price determination. If primary surpluses are determined independently of the level of debt, then the path of the money supply and the price level must satisfy the needs of fiscal solvency; we call this a fiscal dominant (FD) regime. If on the other hand primary surpluses respond to the level of debt in a way that assures fiscal solvency, then money and prices can be determined by the supply and demand for money; we call this a money dominant (MD) regime. The question then is whether monetary or fiscal policy provides the nominal anchor for the economy.
Woodford (1995) emphasize the FD regime, suggesting at one point that “it should be evident that (MD) regimes represent a highly special case.” And indeed many, if not most, general equilibrium models are solved under that assumption. The conventional wisdom, on the other hand, is that monetary policy provides the nominal anchor and most of the empirical models developed at policy making institutions are solved under the assumption of a MD regime.
Clearly, both assumptions can not be right, and it is crucial in many modeling efforts to make the right choice. Consider first the theoretical (or methodological) issues that are at stake. We will show that the choice of regime limits the way in which monetary policy can be modeled. For example, the price level will be over determined in a model in which the central bank tries to set the money supply in a FD regime, and the price level will be undetermined in a model in which the central Ъапк tries to set the nominal interest rate in a MD regime. Furthermore, the choice of regime affects the way in which fixed exchange rate systems can be modeled. Canzoneri, Cumby and Diba (1997a) show that monetary policy alone can not peg the exchange rate in a FD regime. Instead, fiscal policy needs to insure solvency—in effect placing the economy in a money dominant regime—if a peg is to be viable.