Fiscal policy, interest rate shocks and prices

Governments have, in the past, sometimes combined a monetary policy involving setting nominal interest rates with a fiscal policy that only weakly targeted its debt stock. This policy regime has recently been examined under the heading of a 'fiscal theory of the price level'. In this paper we examine what the consequences would be for the price level of a shock to interest rates in this regime. We show that in a variety of models, that relax the assumptions underlying the 'fiscal theory of the price level', a temporary increase in interest rates will raise the price level. This suggests one possible explanation for the 'prices puzzle' noted by Sims. (C) 2002 Elsevier Science B.V All rights reserved.