Gordon and Leeper (2006) embed the quantity theory of money and the fiscal theory of the price level as special cases of a general portfolio-choice model in which the price level depends on current and expected future monetary and fiscal policies through two portfolio-substitution channels: an η\eta (Tobin) channel running from expected distortionary taxation to relative returns on real versus nominal assets, and a μ\mu channel running from expected money growth. The paper's concluding remarks raise a connected empirical agenda: whether and when these channels quantitatively matter in episodes of major policy change — tax reforms, big new spending initiatives, or changes in the inflation target pursued by the central bank — and how to build the more general money-demand specification, including expected fiscal composition, that these circumstances call for. Because monetary and fiscal actions are observationally equivalent in the framework — designating either the fiscal policy change or the monetary policy response as the source of a price-level change is completely arbitrary — measuring the channels must cope with attribution rather than presuppose it.

Background

Two classic accounts determine the price level. The quantity theory of money (QTM) ties the price level PP to the nominal money stock MM through real money balances M/PM/P: with money demand stable, control of MM controls PP. The fiscal theory of the price level (FTPL), developed in the 1990s by Sims (1994) and others, instead treats the government's intertemporal budget constraint as a valuation equation for nominal government liabilities: the price level is the level at which the expected present value of future real primary surpluses backs the outstanding nominal debt, and it can be determined by fiscal outcomes even when the central bank pegs the interest rate. Leeper (1991) classified monetary policies as 'active' (aggressively responding to inflation) or 'passive' and fiscal policies as 'active' (not adjusting taxes to debt) or 'passive', showing that equilibrium determinacy requires exactly one active authority — a classification that organizes when the QTM-like or fiscal-theory-like outcome prevails. Both theories, Gordon and Leeper (2006) argue, suppress the asset-substitution margins emphasized in Tobin's (1969) general-equilibrium approach to monetary theory. They build a growth model in which households substitute among money, government bonds, and physical capital, and distortionary taxes and inflation taxation both distort portfolio choices. Two forward-looking objects drive substitutions: η\eta, a function of expected future tax rates and government spending shares, which governs the relative attractiveness of real assets (the Tobin channel — anticipated higher distortionary taxes lower the after-tax return on capital and shift portfolios toward nominal assets, moving the price level), and μ\mu, a function of expected future money growth (the expected-inflation channel — anticipated money growth depreciates the real value of nominal balances). In this setting the price level depends generically on the whole expected path of both policies; the QTM and the FTPL emerge only under severe restrictions on policy behavior that shut down substitution between real and nominal assets. The theory also delivers a money-demand function that depends not only on the nominal interest rate and a scale variable (such as real income) but on expected fiscal composition — expected tax and government spending policies, which cannot be replaced by a vector of real rates of return, expected inflation, a long-term interest rate, or other typical arguments of money demand; this variable is absent from the specifications used in applied macro modeling. The open questions the paper's concluding remarks raise concern giving this general theory empirical content: measuring the η\eta and μ\mu channels in episodes of major policy change, and building usable money-demand representations that include expected fiscal composition. One framework feature complicates any such measurement: because monetary and fiscal policies jointly determine the price level, 'designating either the fiscal policy change or the response of monetary policy as the source of the price level change is completely arbitrary' — different monetary–fiscal policy combinations can generate identical price-level outcomes.

Problem Statement

The general portfolio-choice theory of the price level of Gordon and Leeper (2006) — in which the quantity theory and the fiscal theory are special cases produced by restricting asset substitution and policy behavior — has not been given empirical content. The open problem is to establish this general theory as a testable, identified framework, specifically: (i) identify and quantify when the portfolio-substitution channels — the η\eta Tobin channel (expected distortionary taxes altering relative returns between real and nominal assets) and the μ\mu expected-money-growth channel — materially determine the price level, where 'material' is a benchmark-relative criterion: a channel is material in an episode when shutting it down shifts the model's predicted price-level response relative to the restricted quantity-theory and fiscal-theory benchmarks (in which the channel is absent) by more than a significance threshold across episodes of major policy change such as tax reforms, large spending initiatives, and changes in inflation-targeting regimes, the circumstances in which the paper predicts the Tobin effect should be important; and (ii) derive and estimate a tractable, policy-invariant money-demand specification in which expected fiscal composition appears alongside the conventional arguments (nominal interest rate and scale variable), so that money demand does not mispredict the price-level effects of expected policy changes; in the model, expected fiscal policies cannot be replaced by a vector of real rates of return, expected inflation, a long-term interest rate, or other typical arguments of money demand. A source-supported difficulty conditions both components: because monetary and fiscal policies jointly determine the price level, 'designating either the fiscal policy change or the response of monetary policy as the source of the price level change is completely arbitrary' within the framework, so measurement of the channels must cope with this observational equivalence rather than presuppose an attribution, and the identification required is a characterization of the monetary–fiscal policy combinations consistent with an observed price level, not an attribution of a given price-level change to one authority; the structural η\eta and μ\mu channel quantification of component (i) is a distinct and legitimate exercise, not the fiscal-versus-monetary attribution that the observational equivalence leaves arbitrary. These components jointly support one objective: replacing the dichotomy between the quantity theory and the fiscal theory with an empirically identified theory of the jointly monetary–fiscal, expectations-driven determination of the price level.

References

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