Chen Lian, Professor, UC Berkeley Economics
Abstract: Does a deficit today necessitate a tax hike tomorrow? In the Fiscal Theory of the Price Level (FTPL), the government commits to never raising taxes, and so in equilibrium the price level adjusts to finance the deficit. This conclusion is controversial: it relies on the government threatening to violate its budget constraint off-equilibrium and selecting a non-fundamental equilibrium, with deficits serving as sunspots. We resuscitate the essence of the FTPL without these controversies in environments where deficits enter aggregate demand because households have finite horizons (OLG) or face liquidity constraints (HANK). Our main result is that in this setting the standard FTPL conclusion—that taxes never need to be adjusted in equilibrium—can emerge along the fundamental equilibrium (aka MSV solution) of this environment. The key condition is that the government promises to adjust taxes with a sufficient delay. The initial deficit then causes a Keynesian boom, and in equilibrium that boom is large enough to finance the deficit that caused it. In our environment this financing happens through two complementary channels: a spike in inflation eroding the real value of public debt—echoing the traditional FTPL—and an increase in output and thereby the tax base—echoing the analysis in De Long and Summers (2012). When we discipline the theory with measurable sufficient statistics, we find that the degree of such ``self-financing'' of fiscal stimulus can be large even with only moderate delays in fiscal adjustment.