Understanding fiscal and monetary policy in through the fiscal theory of the price level By John Cochrane, June 1, 2009 Bruno Solnik: some comments Apologies: I only got the paper days ago and the draft is preliminary.

2 The core of the argumentation  The famous “fiscal policy of the price level”: (1) - Cochrane (2001, 2005), etc… - This is an asset pricing relation

3  “Fiscal inflation” follows more or less the scenario: - if the government is believed to reduce future surpluses through reduction of taxation, then the present value of future surpluses is reduced (assuming constant real discount factor/interest rates). That means both that more money printing will be needed in the future to repay current debt and hence more future inflation and that the current price level P t will rise to restore asset pricing equilibrium.

4 Some current observations by John  Government bonds have becoming “nearly perfect substitutes” to money, given near zero interest rates.  Real interest rates have dropped dramatically (“flight to quality/liquidity”), so Eq. 1 allows to accommodate a much higher supply of Government bonds, without raising current inflation. At least, as long as future surplus/deficits will not be strongly affected.  Follows a lengthy discussion of future inflation using various frameworks, including Laffer and Phillips curves. My basic reading of the text I received is that John expects a rise in US inflation and a depreciation of the dollar.  Such “fiscal” inflation is not associated with growth, and traditional monetary policy tool are old-fashioned.

5  I will let other speak about monetary policy.  I will focus on whether the analysis is US specific

6  Are bond market participants in error? In other words, bond prices will quickly drop.  What if the term structure of real interest rate is upward/downward slopping. Is there a scenario where we would expect future inflation but short-term deflation?  What if banks and other repay debt.

7  The real rate include a default premium. While that maybe small for the US, it can be significant for other countries (as pointed out by John for UK).  In EU government bonds are not exact substitute:  May 14th, the yield on the 10-year German bond was 3.34%. For Spain the yield was 3.96%, for Italy 4.30%, for Ireland 5.07% and for Greece 5.20%. The yield spread between German and Greek bonds was thus 186 basis points. In early March, the yield spread was even higher, over 300 basis points, but the general decrease in risk aversion on financial markets since then have helped to narrow the spread, but even now it is really big.

8  Currency  We know that most other countries have followed the US example (hard not to do it), with stimulus plans, issues of bonds, guarantee programs,…What if other countries experience the same scenario. Why would the dollar crash?