The basic AD-AS model in macroeconomics suggests that an expansionary fiscal policy will lead to an increase in output and price level through a rightward shift of the AD demand curve. Is this not enough to conclude that fiscal policy does have an impact on the price level? How is the fiscal theory of the price level different from this basic AD-AS model (both approaches, at the end, point to the same conclusion)?
In the case to which you refer, the conclusion reached by both approaches is the same, but the way in which they arrive at it is very different.
In case of AD-AS model, the short-run effect of an expansionary fiscal policy is an increase in production and a decrease in unemployment, reflected in increasing wages because of a stronger worker’s bargaining position in the labor market. Higher wages cause the increase in price level through the mark-up rule. We have here wage-driven inflation without any change in money supply.
In case of the fiscal theory of price level, instead, an increase in structural budget deficit causes expectations of a future increase in money supply due to the monetarization of public imbalance. This change in expectations generates immediately an increase in prices, without any change in real terms (production and unemployment). We have here money-driven inflation.
The theoretical roots of AD-AS model are neo-Keynesian, while that of fiscal theory of price level are Monetarist with the addition of Rational Expectations hypothesis.
Hi Rantu Hazarika ,
Andrea Ricci is very much right. The difference between the two approaches is the prediction about the effects of fiscal policy on GDP. Positive in the (keynesian) AD-AS model, almost null in the (neoclassical) models at the basis of the FTPL...
(see Leeper (1991), Leeper and Sims (1994), Woodford (1994, 1995, 1996, 1998a,b), Sims (1994, 1997), Cochrane (1996, 1999a,b,c), Dupor (1997), Loyo (1997a,b), Luttmer (1997), Olivei (1997); critical evaluations include Canzoneri et al. (1998a,b), Buiter (1998, 1999), McCallum (1998), Clements et al. (1998) and Janssen et al. (1999).)
The prior answers are correct. I can only add that there is a long and short run distinction. The AD AS model allows fiscal policy to affect the general level of economic activity and therefore the price level in the short run. In the long run, even in a highly Keynesian model, the only way fiscal policy can affect the price level is if it affects the growth path. If it does not affect that (through a variety of possible routes including affecting productivity via investment) then in the long run the money supply should determine the price level. Of course, there is always the question--how long it the long run?
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