A Frictionless View of U.S. Inflation

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Abstract
Financial innovation challenges the foundations of monetary theory, and standard monetary theory has not been very successful at describing the history of U.S. inflation. Motivated by these observations, I ask: Can we understand the history of U.S. inflation using a framework that ignores monetary frictions? The fiscal theory of the price level allows us to think about price-level determination with no monetary frictions. According to this approach, the price level adjusts to equilibrate the real value of nominal government debt with the present value of surpluses. I describe the theory, and I argue that it is a return to pre-quantity-theoretic ideas in which money is valued via a commodity standard or because the government accepts it to pay taxes. Both sources of value are immune to financial innovation and the presence or absence of monetary frictions. I then interpret the history of U.S. inflation with a fiscal-theory, frictionless view. I show how the fiscal theory can accommodate the stylized fact that deficits and inflation seem to be negatively, not positively correlated. I verify its prediction that open-market operations do not affect inflation. I show how debt policy has already smoothed inflation a great deal.

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