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It may be helpful to give our bottom line at the outset, so that the reader will know what to look for: we think the post war US data reject the hypothesis of a FD regime. We will present what we think is convincing evidence in favor of the MD regime, and therefore the conventional view of price determination. Kremers (1989) found some evidence for a switch in surplus policy after 1980, and so do we. However, if there is a new regime in place, we find no evidence that it is a FD regime.


We begin this section with a review of the theory of price determination that was developed by Auemheimer and Contreras (1990), Leeper (1991), Woodford (1994, 1995) and Sims (1994, 1995). Once the basic theory is laid out, we present a Proposition that illustrates the breadth of the class of fiscal policy rules that lead to MD regimes. Then, we develop the restrictions that will allow us to distinguish between MD and FD regimes empirically.

The new theory of price determination revolves around the way in which the government’s present value budget constraint gets satisfied. The reduced form for the price level will of course depend upon the way in which the rest of the economy is modeled, and that has been done in a variety of ways. However, the defining features of MD and FD regimes can be explained in terms of the budget constraint alone. The theory is, in this sense, quite general. In nominal terms, the government’s budget constraint for period j can be written as
where Mj and Bj are the stocks of base money and government debt at the beginning of period j, Tj – Gj is the primary surplus during period j, and ij is the interest rate for period j. The constraint says that the existing debt has to be paid off, monetized, or refinanced. It should be emphasized that we are assuming the government issues nominal liabilities (M and B); while the nominal values of these liabilities are fixed at the beginning of the period, their real values depend on the price level. We will see the importance of this assumption shortly.