The fiscal theory of the price level in an open economy

Abstract

Recent work (Loyo, E., Going international with the fiscal theory of the price level. Manuscript, John F. Kennedy School of Government, Harvard University, 1998; Dupor, B., Exchange rates and the fiscal theory of the price level. Journal of Monetary Economics 45, 613–630) has shown that extension of the fiscal theory of the price level to an open economy yields indeterminate prices and exchange rates, calling into question the usefulness of the theory. This paper shows that by carefully tailoring policies in an independent fashion, governments can eliminate price and exchange rate indeterminacy. Specifically, governments are assumed to care about the welfare of their agents so that they never set policy to yield an intertemporal government budget surplus.