The Central Bank, the Treasury, or the Market: Which One Determines the Price Level?

This paper studies a model in which the price level is the outcome of dynamic strategic interactions between a fiscal authority, a monetary authority, and investors in government bonds and reserves. The unpleasant monetarist arithmetic whereby aggressive fiscal expansion forces the monetary authority to chicken out and inflate away public liabilities may be contained by market forces: Monetary dominance prevails if such fiscal expansion is met with a higher real interest rate on public liabilities, due for example to the crowding out of private investment opportunities. The model delivers empirical implications regarding the joint dynamics of public liabilities and price level, and policy implications regarding the management of central banks' balance sheets.