Statement
The equilibrium price level is that level that makes the real value of nominally denominated government liabilities equal to the present value of expected future government budget surpluses
— Woodford, 1995
In nominal terms, government must pay off its existing liabilities (government debt) either by:
- refinancing
- rolling over the debt, issuing new debt to pay the old
- amortizing
- paying it off from surpluses in tax revenue
...or defaulting on the debt.
In real terms, a government can also inflate away the debt: if it causes or allows high inflation, the real amount it must repay will be smaller.
Thus the fiscal theory states that if a government has an unsustainable fiscal policy, such that it will not be able to pay off its obligation in future out of tax revenue (it runs a structural deficit), then it will pay them off via inflating the debt away. Thus, fiscal discipline, meaning a balanced budget over the course of the economic cycle (meaning, on the whole, running surpluses in expansions and deficits only in contractions), is necessary for the price level to remain stable: unsustainable deficits will require inflation in future.
Read more about this topic: Fiscal Theory Of The Price Level
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