Monetary Policy in a Fiscal Theory Regime ∗

This paper considers the role for monetary policy in a regime in which the “Fiscal Theory of the Price Level ” (FTPL) applies and in which the government issues long-term debt. Cochrane (2001) shows that the fiscal authority can use a commitment to maintain a fixed maturity structure of government debt to fully determine the impact and dynamic effects of present-value-surplus shocks on inflation in a cashless economy. We show that in a monetary economy, in which Cochrane’s fiscal commitment to ma-turity structure is replaced with a monetary commitment to a state-contingent interest rate rule, the monetary authority becomes responsible for the timing of inflation. We derive interest rate rules, which minimize the variance of inflation around a target, and show the interest rate will respond positively to shocks raising inflation and to shocks raising output above trend, as with a Taylor Rule