What Determines the Price Level?

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What determines the price level and inflation rate of an economy? This has been a central question because the nature of the price level determination is fundamental to understanding other important issues such as the business cycle, stock market fluctuations, monetary and fiscal policy design and exchange rate determination.

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The standard answer to the question is that the price level and inflation is purely a monetary phenomenon: they are primarily or exclusively determined by the central bank through its ability to control the money supply. Accordingly, many economists view that fiscal factors are unimportant for the price level determination. Due to the conventional view, macroeconomic models that are currently estimated and used for the analysis of monetary policy and business cycles typically abstract from fiscal policy, as best exemplified by the medium scale dynamic stochastic general equilibrium models in Christiano, Eichenbaum and Evans and Smets and Wouters. However, this conventional approach is not without critics.

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