9709420 Cochrane This project consists of two parts: 1. Theoretical and empirical investigation of the fiscal theory of the price level. The fiscal theory states that the price level is determined by the ratio of the nominal value of total government (or "outside") debt to the real value of (net of interest) fiscal surpluses that will pay off the debt. This theory establishes a direct connection between fiscal events and the price level. The fiscal theory may help resolve a host of empirical embarrassments of monetary economics. These include exchange rates (another measure of the price level) that seem to have little to do with relative money stocks and a relation between monetary aggregates and the price level that is notoriously unstable. This project adds long-term debt to existing theoretical treatments; finds conditions when news of future deficits can lead to inflation today, and when it leads only to a decline in the price of long-term bonds; solves for the optimal maturity structure of government debt that achieves price level objectives; and provides the first rigorous empirical tests of fiscal theory. 2. "Good deal" asset pricing bounds. Pricing by arbitrage, in which one learns about the price of a given payoff from prices of "nearby" payoffs, is very attractive to many practical and economic applications of asset pricing theory including investment theory, corporate finance and even environmental economics (the rainforest as an option on a cure for cancer). Unfortunately, the absence of arbitrage tells us nothing about the price of a specific untraded financial instrument. This project develops a new method for calculating tight upper and lower bounds for the "fair values" of untraded financial instruments from the prices of related assets and a little information about the underlying economics. ??
