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Marcus Hagedorn, Ph.D.

University of Oslo, Norway

Author: Marcus Hagedorn

Abstract: In this paper I show that the price level is globally unique in incomplete markets models. I base my argument on the simple idea that the price equates demand with supply in the goods market. Monetary policy works through setting nominal interest rates, e.g. an interest rate peg, while fiscal policy is committed to satisfying the present value budget constraint at all times (in contrast to the FTPL).  Together, these determine the unique price level, as well as consumption and employment, jointly.  In particular, the model predicts a unique equilibrium in response to a fiscal stimulus if the nominal interest is pegged, whereas there is a continuum of equilibria in the standard New Keynesian model. In contrast to the conventional view the long-run inflation rate is, in the absence of output growth, equal to the growth rate of nominal government spending, which is controlled by fiscal policy.  This new theory where nominal government spending anchors aggregate demand, and therefore current and future prices, offers a different perspective on a range of important issues including the fiscal and monetary transmission mechanism, policy coordination, policies at the zero-lower bound, U.S. inflation history and recent attempts to stimulate inflation in the Euro area.

JEL Classification: D52, E31, E43, E52, E62, E63

Keywords: Price level, Incomplete Markets, Inflation, Monetary Policy, Fiscal Policy

Full Text:  “A Demand Theory of the Price Level”