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THE PRICE LEVEL: TESTING FOR FISCAL DOMINANCE

This discussion does however suggest a way to differentiate between MD and FD regimes. Consider how a positive innovation in st passes to wt+1. In a MD regime, the surplus pays off some of the debt, and wt+1 falls. In a FD regime, there are several possibilities. Consider first the case in which an innovation in st is not correlated with the surpluses and discount factors that follow st on the RHS of (4). In a FD regime, the value of wt+1 can be found by shifting (4) forward one period.

In the case we are considering, w,+1 should not be affected by the innovation in st. Consider next the case in which an innovation in s, is positively correlated with future surpluses and discount factors. In this case, wt+1 should rise. In either of these cases, it should in principle be possible to differentiate between MD and FD regimes. For example, the impulse response function from a VAR in s, and wt would tell us how wt+1 responds to an innovation in st. If wt+l falls, we have an MD regime; if it does not, we have a FD regime.


Unfortunately, there is also a third case to consider. Suppose innovations in s, are negatively correlated with future surpluses and discount factors. In this case, wt+1 would fall in either a MD regime or a FD regime, and we have an identification problem. We will have to check for this possibility.

TESTING FOR FISCAL DOMINANCE

In this section, we use annual data from 1951 – 1995 to determine whether the US has been in a MD regime (as most empirical policy analyses assume) or a FD regime. To do this, we use the data illustrated in Figure 2 to test the restrictions that were discussed at the end of the last section. Liabilities/GDP corresponds to wt in the last section; it is calculated by adding the net federal debt to the money base, both measured at the beginning of the fiscal year, and dividing by nominal GDP for the fiscal year.16 Surplus/GDP corresponds to st.