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Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page Price Level Determinacy and Monetary Policy under a Balanced Budget Requirement
Stephanie Schmitt-Grohe and Martin Uribe

Abstract: This paper analyzes the implications of a balanced budget fiscal policy rule for the determinacy of the price level in a cash-in-advance economy under three alternative monetary policy regimes. It shows that, in such stylized models with flexible prices and a period-by-period balanced budget requirement, the price level is determinate under a money growth rate peg and is indeterminate under a pure nominal interest rate peg. Under a feedback rule whereby the nominal interest rate is set as an increasing function of the inflation rate, the price level is determinate for intermediate values of the inflation elasticity of the feedback rule and is indeterminate for both very low and very high values of the inflation elasticity. Finally, regardless of the particular monetary policy specification, a rational expectations equilibrium consistent with the optimal quantity of money may not exist.

Keywords: Balanced budget rules, price level determinacy

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Last update: July 16, 1997