DP3564 Policy Interaction, Learning and the Fiscal Theory of Prices

Author(s): G W Evans , Seppo Honkapohja

Publication Date: October 2002

Keyword(s): inflation , expectations , fiscal and monetary policy , explosive price paths

JEL(s): D84 , E31 , E52

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3564.asp

We investigate both the rational explosive inflation paths studied by McCallum (2001), and the classification of fiscal and monetary policies proposed by Leeper (1991), for stability under learning of the rational expectations equilibria (REE). Our first result is that the fiscalist REE in the model of McCallum (2001) is not locally stable under learning. In contrast, in the setting of Leeper (1991), different possibilities can arise. We find, in particular, that there are parameter domains for which the fiscal theory solution, in which fiscal variables affect the price level, can be a stable outcome under learning. For other parameter domains, however, the monetarist solution is instead the stable equilibrium.