We investigate both the rational explosive inflation paths studied by McCallum (2001) and the classification of fiscal and monetary policies proposed by Leeper (1991) for stability under learning of rational expectations equilibria (REE). Our first result is that the fiscalist REE in the model of McCallum (2001) is not locally stable under learning. By contrast, in the setting of Leeper (1991), different possibilities can obtain. We find, in particular, that there are parameter domains for which the fiscal theory solution – in which fiscal variables affect the price level – can be a stable outcome under learning. For other parameter domains, the monetarist solution is the stable equilibrium.
Introduction: Interactions between fiscal and monetary policy in the determination of the price level have been the object of a great deal of new research in recent years. One relatively new strand of research, the fiscal theory of the price level asserts that fiscal policy can have an important influence on the price level in models in which one expect prices to depend only on monetary variables.
Author: George W. Evans, Seppo Honkapohja
Source: Research Discussion Papers, Bank of Finland
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