There are two versions of the fiscal theory of the price level (FTPL); one true, the other false. The true version holds that if the fiscal authority dominates the policy space, then fiscal deficits could be monetized by the central bank. This version is consistent with the quantity theory of money, because inflation is ultimately determined by excess growth in the money supply. If money growth were constant, inflation could not occur—that is, there could not be a sustained rise in the average level of money prices. In this sense, Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” cannot be refuted (Friedman 1970: 11).
The second version of the FTPL, the so-called strong version, holds that even if the money supply is held constant, inflation can occur if the fiscal authority is passive.[1] All that is needed is for the public to expect prices to rise. People will then spend their given money balances at a faster rate — increasing the velocity of money — and prices will rise until expectations change. If the fiscal authority is passive, velocity can explode, producing hyperinflation (see McCallum and Nelson 2005). This feature of the strong version is referred to as “speculative inflation” and is independent of monetary policy (Tutino and Zarazaga 2014: 3). The strong version also implies that fiscal action—not monetary reform—is the primary tool for ending a hyperinflation. This version of the FTPL is false: it ignores historical evidence that shows the determining factor in generating hyperinflations is explosive growth in the money supply (or the expectation that such growth will occur); and it fails to recognize that stabilization results from credible monetary reform.[2]
Expectations about future inflation don’t appear like manna from heaven — businesses and households know that excess money growth causes inflation. They also know that large unfunded government liabilities and budget deficits risk having the central bank monetize debt. Although the strong version of the FTPL assumes away that possibility, history does not.