Lecture Monetary, Fiscal and Financial Policy

Harold L. Cole
University of Pennsylvania
October 7, 2012
Contents
1 The Overlapping Generations Model 3
1.1 Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2 Pareto Optimality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3 Social Planning Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2 Market Outcomes with Money 11
2.1 Equilibrium without Money . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2 Equilibrium with Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.2.1 Aggregation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3 Barter Exchange vs. Monetary Exchange 17
4 Commodity Money 19
5 Ination 21
6 Money Growth, Ination and Output 25
7 Stochastic Money and Prices 27
7.1 Stochastic Bubbles and Collapses . . . . . . . . . . . . . . . . . . . . . . . . 27
7.2 Stochastic Money Growth I . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
7.2.1 Three Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
7.3 Intellectual History of Ination vs. Unemployment Trade-o . . . . . . . . . 35
7.4 Stochastic Money Growth II: Price Surprises . . . . . . . . . . . . . . . . . . 38
7.5 Lucas 1: Worker Inference Problem . . . . . . . . . . . . . . . . . . . . . . . 38
7.6 Lucas 2: An Equilibrium Misperceptions Model . . . . . . . . . . . . . . . . 42
7.6.1 Log-linearization on the Road to Truth . . . . . . . . . . . . . . . . . 46
7.6.2 Hopefully Clarifying Example . . . . . . . . . . . . . . . . . . . . . . 48
8 New Keynesian Model 51
8.1 Deriving the Demand Function . . . . . . . . . . . . . . . . . . . . . . . . . 56
1
9 The Bond Market and Government Debt 58
10 Debt, Spending and Ination 60
11 Capital and Production 62
11.1 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
11.2 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
11.3 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
11.4 Savings and Eciency in the Steady State . . . . . . . . . . . . . . . . . . . 68
11.5 Government Debt and the Capital Stock . . . . . . . . . . . . . . . . . . . . 71
11.6 Should We Tax Capital to Raise Revenue? . . . . . . . . . . . . . . . . . . . 71
12 Labor, Taxes and Cross-Country Hours 74
12.1 European vs. U.S. hours worked and taxes . . . . . . . . . . . . . . . . . . . 75
13 Altruism and the Timing of Taxation 76
14 Math Review 78
14.1 Optimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
14.2 Probability Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
14.3 Time Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
2
1 The Overlapping Generations Model
We use the overlapping generations model (OLG) in this text. The overlapping generations
model (OLG) was rst introduced by Samuelson (1958), and it is a dynamic model with a
demographic structure. The model contains agents who are born at dierent dates and live
nite lives. Because there is an innite succession of these households, the model goes on
forever. This is important for examining the role of nancial assets; money in particular.
One interesting aspect of this model is that there is a natural heterogeneity among the
individuals at a point in time because of dierences in their age. In addition, Individuals
have life-cycle considerations because they face the standard cycle of birth, aging and death.
Versions of this model have been used to examine the role of money, monetary policy and
scal policy.
We will focus on a special case of the OLG model in which the agents in our economy
live only two periods and do not care about future generations. In the rst period of their
lives agents are born, work and save (called the "young"). In the second period of their lives
agents consume and die. The major analytic convenience of two-period lived structure is
that the future payo from savings or investment is very simple which allows us to model
this activity with the minimum of technical sophistication.
The cost of our two-period lived structure is that a period here is roughly a generation,
which is pretty long. Another cost of our structure is that we will assume that people
dont care about future generations. Longer multi-period lives are possible, which makes
the model more useful for examining short-run issues and better able to match important
features of the data. One can also relax the assumption that people dont care about future
generations, especially with respect to their own ospring. However, these changes in the
models assumptions make it considerably more complicated. As a result, we will generally
stick with our simple structure and take it as far as we can.
In so doing, we must clearly confront the fact that we are using an inherently unrealistic
model within which to think about issues of monetary and scal policy. The truth is, this
problem is always with us, since all models are abstractions and hence false. Its just that in
models with realistic detail, the extent of the "falsity" can be less obvious. None the less, it
is always there. For this reason, one of the key aspects of analytic reasoning is learning how
to use false models well. By this I mean coming to grips with the strengths and weakness of
your model and trying to use it for issues for which it is well design and also understanding
how the weakness of your model will limit the nature of the answers that it can deliver.
For example, the long time period limits the ability of the model to analyze short-term
issues like business cycles. It also makes it harder to use the model to quantitatively analyze
issues like the cost of ination since the holding period of money is tied to the period length.
In certain cases, the analytic diculty associated with more complicated versions of our
model may be worth it. For example, when we consider certain issues with respect to the
timing of debt and taxes, we will relax the assumption that the people dont care about
future generations and see that this leads to a very dierent conclusion than if they dont.
3
1.1 Environment
This is a discrete time model with t indexing time periods; t = 1. 2. 3. ... . In each period
a new young generation is both with `
t
members. Each generation lives for two periods, so
that in each period t 1. there will be two generations alive simultaneously. To preserve
this structure in the rst period t = 1. we will assume that there is an initial old generation
composed of `
0
members. Each member of a young generation born in period t is endowed
with
t
units of a nonstoreable consumption good in the rst period of life and nothing in
the second period. We can interpret this endowment as labor income which is produced by
labor which they supply inelastically to produce output.
The young have preferences over consumption in both periods of their lives, while the
initial old have preferences over consumption in the one period in which they are alive. We
will denote consumption by the young in period t by c
1;t
and by the old in period t by c
2;t
.
Given this notation, the consumptions of a person born in period t are c
1;t
and c
2;t+1
. Their
preferences are given by l(c
1;t
. c
2;t+1
). and we will assume that l is nice in that l
i
0.
l
ii
< 0. and that the preferences implied by l are convex (which implies that l itself is a
concave function). We will assume that l
1
(0. c) = l
2
(c. 0) = for any c _ 0. and hence
people really want consumption in both periods of their lives. The initial old are assumed to
have preferences \(c
2;1
) where \
0
0 and \
00
< 0. Because there is no systematic change
in choices over consumption between young and old as people become richer, we will assume
that l is homothetic,
l
1
(c
1
. c
2
)
l
2
(c
1
. c
2
)
=
l
1
(cc
1
. cc
2
)
l
2
(cc
1
. cc
2
)
for any c 0. This implies that the marginal rates of substitution depend upon relative
levels of consumption.
A feasible allocation is a sequence of consumption choices for the young and the old in
each period, c
1t
. c
2t

1
t=1
. which does not violate our resource constraint
`
t
c
1t
+ `
t1
c
2t
_ `
t

t
In the special case in which population and income is constant is constant (i.e. `
t
= ` and

t
= for all t). this reduces down to the following simple condition
c
1
+ c
2
_ .
For simplicity, we will assume that both population and output per young person grows
at constant rates. In particular, we assume that the population grows at the rate (1 + :)
and that the level of output in each generation grows at the rate (1 + q). This implies that
`
t+1
= (1 + :)`
t
.

t+1
= (1 + q)
t
.
and that the level of total output in period t. 1
t
. is therefore given by
1
t
= `
t

t
= (1 + :)
t1
(1 + q)
t1
`
1

1
.
4
Note that this implies that the total amount of resources are growing at the gross rate
(1 +:)(1 +q) 1 +:+q. since :q is taken to be quite small. This implies that the net rate
of growth of output is roughly the sum of the two growth rates of population and output
per young person.
1.2 Pareto Optimality
A Pareto ecient arrangement is one in which no persons welfare can be improved without
making someone elses welfare fall. This criteria takes account of the fact that people know
who they are at the time that theyre considering a change in the allocation. If we start
from the initial allocation implied by autarky, then
c
1t
= (1 + q)
t1

c
2t
= 0.
and the individuals payo is
l(c
1t
. c
2t+1
) = l
_
(1 + q)
t1
. 0
_
.
If we look at their marginal rate of substitution (MRS) between rst and second period
consumption and it is given by
l
2
(c
1t
. c
2t+1
)
l
1
(c
1t
. c
2t+1
)
=
since we have assumed that l
2
(c. 0) = . This means that people would place tremendous
value on having a small amount of additional consumption in their old age starting from
their initial allocation or autarky. Clearly some way of allowing people to have consumption
while old could make everyone better o.
Consider a system of transfers that takes
t
from the current young, divides it up among
the current old, and then gives the future young A
t
when they are old to be equally divided
up among them. Since output and population is growing, we have allowed for the possibility
of growth in the transfers. In particular, under this system the transfers are growing at rate
A :
t
= A
t1

1
. where
1
is the transfer in the initial period. For this system of transfers
to be feasible, it must be the case that
A
t1

1
_ 1
t
= `
t

t
= (1 + :)
t
(1 + q)
t1
.
Clearly,
A _ (1 + :)(1 + q).
or for any
1
0 we will eventually violate this constraint.
If we look at these transfers in terms of what an individual gives up and gets, they give
up
t
,`
t

t
`
t
=
A
t1
(1 + :)
t1

1
`
1
.
and receive
A
t
`
t
=
A
t
(1 + :)
t1

1
`
1
.
5
hence their rate of return, which is the ratio of what they get over what they give up is A.
Clearly the individual would like his return A to be as large as possible since that increases
his benet. This implies that we should set A = (1 + :)(1 + q). Note that is this case, the
per person payments and receipts are growing at rate (1 + q). which is the same as their
income.
Given a return A, we could ask an individual how large would they like the scale of the
initial transfer
t
,`
t
to be. An individual born in period t would have a payo of
l
_
(1 + q)
t1


t
`
t
. A

t
`
t
_
.
The change in the individuals payo from changing
t
is given by the derivative of his payo
with respect to (w.r.t.)
t
and at the optimum, this derivative would be zero, or
l
1
_
(1 + q)
t1


t
`
t
. A

t
`
t
_
1
`
t
+ l
2
_
(1 + q)
t1


t
`
t
. A

t
`
t
_
A
`
t
= 0.
Now, if A = (1 + :)(1 + q) then we can rewrite this expression as
l
2
_
(1 + q)
t1

[(1+g)(1+n)]
t1
(1+n)
t1
"
1
N
1
.
[(1+g)(1+n)]
t
(1+n)
t1
"
1
N
1
_
l
1
_
(1 + q)
t1

[(1+g)(1+n)]
t1
(1+n)
t1
"
1
N
1
.
[(1+g)(1+n)]
t
(1+n)
t1
"
1
N
1
_ =
1
(1 + :)(1 + q)
.
Then, we can simplify this expression to get
l
2
_
(1 + q)
t1
[(1 + q)]
t1 "
1
N
1
. (1 + q)
t
(1 + :)
"
1
N
1
_
l
1
_
(1 + q)
t1
[(1 + q)]
t1 "
1
N
1
. (1 + q)
t
(1 + :)
"
1
N
1
_ =
1
(1 + :)(1 + q)
.
Then, we note that the term (1+q)
t1
is scaling up both rst and second period consumption,
and because our preferences are homothetic, it will cancel out leaving
l
2
_
(1 + q)
t1
[(1 + q)]
t1 "
1
N
1
. (1 + q)
t
(1 + :)
"
1
N
1
_
l
1
_
(1 + q)
t1
[(1 + q)]
t1 "
1
N
1
. (1 + q)
t
(1 + :)
"
1
N
1
_
=
l
2
_

"
1
N
1
. (1 + q)(1 + :)
"
1
N
1
_
l
1
_

"
1
N
1
. (1 + q)(1 + :)
"
1
N
1
_
=
1
(1 + :)(1 + q)
.
The rst thing to note about this optimality condition is that there is no "t" terms anywhere.
Hence, the optimum choice of
1
does not depend upon which generation one is born into.
The reason for this is that the growth rate of the per person transfers is the same as the
growth rate of his income and thus the relative levels of c
1t
and c
2t+1
do not change over time.
6
With homothetic preferences the optimal choice depends upon the ratio of consumptions.
Thus, we get our result.
If the growth rate of the gross transfers, A. had been less than (1 + :)(1 + q). then
this would imply that the per person transfers would be growing at a rate less than 1 + q.
and hence would be shrinking over time relative to income. As a result, c
2t+1
,c
1t
would be
going to zero. Thus, for individuals born into later generations where t is large, the transfer
scheme would eectively be disappearing.
Remark 1 A Pareto optimal arrangement is one in which the allocation cannot be improved
upon for any individual without making someone else worse o. If
l
2
(c
1t
. c
2t+1
)
l
1
(c
1t
. c
2t+1
)

1
(1 + :)(1 + q)
for all t. then we could improve on things by having the young give up the fraction of their
endowment today which is equally distributed among the old in each generation. This would
lead to each young person giving
t
today in exchange for (1 +:)(1 +q)
t
tomorrow. This
exchange is feasible and makes everyone better o including the initial old. Note that this
condition does not work in the reverse since the initial old would never want to given up
anything.
Problem 2 Assume that the consumption levels are given by
c
1;t
= (1 + q)
t1
c
1
.
c
2;t
= (1 + q)
t1
c
2
.
so the entire consumption sequence for both the old and the young are determined by two
numbers c
1
and c
2:
Use the time t resource constraint to derive the fundamental restriction
on c
1
and c
2
that must hold to ensure that consumption equals output in each period.
Assume that the individuals preferences over consumption is given by
c
1
1t
1 c
+ ,
c
1
2t+1
1 c
.
and note that
d
dc
_
c
1
1 c
_
= c

.
Using these preferences, write down the optimization problem for a young person born at
time t with respect to the choice of c
1
and c
2
. Derive the optimality or rst-order conditions
for this problem. Use them along with your resource constraint to characterize as well as
possible the optimal choices of c
1
and c
2
.
Show that the optimal choices of c
1
and c
2
do not depend upon the age of the young person.
Discuss how this features depends upon the homothenticity of our assumed preferences.
7
1.3 Social Planning Problems
Assume that we have a social planner who is going to determine the appropriate arrangement
in our economy. Social Planning problems are often used to determine optimal arrangements.
However, the answer that emerges depends however on how much weight a particular agent
gets in the social planning problem.
For simplicity, we will assume that the number of initial old is 1. The resource constraint
in each period governs the available supply of goods that we can feasibly allocate. An
allocation is a sequence of consumptions for young and old c
1t
. c
2t

1
t=1
. We will assume that
preferences are given by
l(c
1t
. c
2t+1
) = n(c
1t
) + ,n(c
2t+1
)
We will assume that the social planners objective is given by
n(c
2;1
) +
1

t=1
,
t1
l(c
1t
. c
2t+1
).
With this objective, were assuming that the planner cares about the average or represen-
tative agents payo for each generation, but not about the number of members of each
generation. This is consistent with an individual who cares about his potential lifetime pay-
o, and who takes the likelihood of being born in any generation as being equal. (Note that
the individual isnt being a very good statistician here.) Well discuss below relaxing this
assumption.
Remark 3 In both the individuals and the social planners objectives, we have assumed that
there is some discounting of the future so that , < 1. The reason for this is that

1
t=1
is
equal to if 0. and if < 0. Hence, we need some discounting to have the problem
be well posed. This discounting needs to be larger if the plan cares about people rather than
generations (and hence weights each generation by their number if : 0).
The planners problem is to choose the optimal feasible allocation, which is given by the
solution to
max
fc
1t
;c
2t
g
1
t=1
n(c
2;1
) +
1

t=1
,
t1
l(c
1t
. c
2t+1
)
subject to
(1 + :)
t
(1 + q)
t1
= (1 + :)
t
c
1t
+ (1 + :)
t1
c
2t
in each period. We can write this problem as a Lagrangian
max
fc
1t
;c
2t
g
1
t=1
n(c
2;1
) +
1

t=1
,
t1
l(c
1t
. c
2t+1
)
+
1

t=1
`
t
_
(1 + q)
t1
c
1t
+ (1 + :)
1
c
2t
_
.
8
where we have divided the resource constraint by (1+:)
t
. Then, make a change in variables,
by replacing `
t
= ,
t1

t
,(1 + q)
t1
. and the problem can be expressed as
max
fc
1t
;c
2t
g
1
t=1
n(c
2;1
) +
1

t=1
,
t1
_
n(c
1t
) + ,n(c
2t+1
)+

t
[ c
1t
,(1 + q)
t1
+ (1 + :)
1
c
2t
,(1 + q)
t1
]
_
.
We can then form the rst order condition c
1t
and c
2t
by taking the derivatives with
respect to these terms separately to get
,
t1
_
n
0
(c
1t
)
t
,(1 + q)
t1

= 0
and
,
t2
,n
0
(c
2t
) (1 + :)
1
,
t1

t
,(1 + q)
t1
= ,
t1
_
n
0
(c
2t
) (1 + :)
1

t
,(1 + q)
t1

= 0.
In addition, if we dierentiate by
t
we get the resource constraint.
Combining the rst two rst-order conditions, we get that in each time period, the
allocation for the current young c
1t
and old c
2t
is being chosen to satisfy
n
0
(c
1t
)
n
0
(c
2t
)
= 1 + :
and
c
1t
,(1 + q)
t1
+ (1 + :)
1
c
2t
,(1 + q)
t1
.
Remember from before that our preferences are homothetic. In our context, this assump-
tion implies that if
n
0
(c
1
)
n
0
(c
2
)
= 1 + :.
then
n
0
((1 + q)
t1
c
1
)
n
0
((1 + q)
t1
c
2
)
= 1 + :.
Hence the solution is of the form
c
1t
= (1 + q)
t1
c
1
c
2t
= (1 + q)
t1
c
2
.
This implies that we do get a stationary solution along the lines assumed in CF.
If we look at the marginal rate of substitution for an individual, we see that
,n
0
(c
2t+1
)
n
0
(c
1t
)
=
,(1 + :)
1

t+1
,(1 + q)
t

t
,(1 + q)
t1
=
,
(1 + :)(1 + q)

t+1

t
.
To understand the role of the Lagrangian multiplier
t
. note that if we dierentiate the
Lagrangian with respect to (w.r.t. henceforth) . we get ,
t1

t
. Hence, ,
t1

t
measures
the benet to our objective of a small increase in . Remember that output in period t is
9
(1 +q)
t1
(1 +:)
t
. so this is not the benet of an increase in total output or even individual
output. If we wanted those values, then they would be given by
,
t

t
(1 + q)
t1
(1 + :)
t
and
,
t

t
(1 + q)
t1
respectively. From our results, it follows that
n
0
(c
1t
) = n
0
((1 + q)
t1
c
1
) =
t
,(1 + q)
t1
.
or

t
= n
0
((1 + q)
t1
c
1
)(1 + q)
t1
.
Note that if q = 0. then
t
is constant over time.
Remark 4 If there is no growth, q = 0. then
t+1
,
1
= 1. and the social planning problem
implies that
,n
0
(c
2t+1
)
n
0
(c
1t
)
=
,
(1 + :)
.
If we did social planning based upon a utilitarian basis, we would weight people and not
generations.
1
In this case, the social planning criterion would be
n(c
2;1
) +
1

t=1
,
t1
(1 + :)
t
l(c
1t
. c
2t+1
).
In this case, it is useful to have the resource constraint in per person terms, and form the
Lagrangian as
max
fc
1t
;c
2t
g
1
t=1
n(c
2;1
) +
1

t=1
,
t1
(1 + :)
t
_
n(c
1t
) + ,n(c
2t+1
)+

t
[ c
1t
,(1 + q)
t1
(1 + :)
1
c
2t
,(1 + q)
t1
]
_
.
If we construct the f.o.c.s they will yield
,
t1
(1 + :)
t
_
n
0
(c
1t
)
t
,(1 + q)
t1

= 0
and
,
t2
(1 + :)
t1
,n
0
(c
2t
) ,
t1
(1 + :)
t1

t
,(1 + q)
t1
= ,
t1
(1 + :)
t1
_
n
0
(c
2t
)
t
,(1 + q)
t1

= 0.
1
This would also be true if people thought that they were going to be assign randomly to be one of these
people. To see this assume that there were N chairs and N people who were going to be randomly placed in
these chairs. Assume that the chairs were in Y dierent rooms, with the number of chairs varying by room.
The likelihood of you getting a particular chair is 1=N: From this it follows that the likelihood of your being
in a particular room is the ratio of the number of chairs in that room relative to the total number of chairs.
10
The second expression comes from the fact that we put relatively less weight on the con-
sumption of the representative old person because their are fewer of them. This yields
n
0
(c
1
) = n
0
(c
2
).
as our optimal condition. Note that it will still be true that
c
1t
= (1 + q)
t1
c
1
c
2t
= (1 + q)
t1
c
2
.
and we get a stationary solution along the lines assumed in CF. However, the intertemporal
trade-o will no longer favor giving more to the old because there are fewer of them
,n
0
(c
2t+1
)
n
0
(c
1t
)
=
,
t+1
,(1 + q)
t

t
,(1 + q)
t1
=
1
(1 + q)
,
t+1

t
.
The dierence between the generational-weighting social planners problemand the population-
weighted one, is that it takes into account that there are more people in future generations
in deciding the optimal arrangement. This make sense for an ex ante perspective. How-
ever, if people know which generation they were going to be born into, then they would be
evaluating any system of transfers from an ex post sense (i.e. knowing who they were).
2 Market Outcomes with Money
Here we want to consider what are the decentralizable outcomes from our model. A decen-
tralizable outcome is one in which the actions of the individuals are not determined by some
central planner. Instead they are determined by the individuals optimal choices given the
set of market arrangements available. This means that outcomes will occur in competitive
markets in which prices will dictate relative exchanges of one good or asset for another. In
this these exchanges the individuals will only engage in mutually benecial trades, where by
mutually benecial we mean that these actions maximize the individuals welfare over the
set of feasible actions. In these exchanges, we will assume that all agents are small and that
they do not coordinate they behavior. Hence, they will be acting as price-takers in that they
cannot eect the overall price in the market..In addition, we will require that at this prices
supply equals demand since implicitly we are assuming that if this wasnt the case then one
of the supplier can lower its price or one of the demanders could raise its price. This will
enable them to outbid another seller or buyer in an individual trade and hence get to sell or
buy the good they desire.
2.1 Equilibrium without Money
In the equilibrium of this version of the economy there is no double coincidence of wants.
That is, there is no group of currently alive agents for whom there is a mutually benecial
set of trades. The reason for this is that the current old have nothing and want current
consumption, while the current young have something and want future consumption. Hence
11
the only equilibrium outcome is autarky in which each individual simply eats his endowment
when young and eats nothing when old. This outcome is extremely inecient from the
point of view of the social planner since the type of intergenerational exchanges shown to
be optimal there would be strongly welfare improving given that l
2
(. 0) was a big number
(which were assuming).
2.2 Equilibrium with Money
We will assume initially there is a at currency which can only be produced by the govern-
ment. By at we mean that the currency can only be used in exchange and is otherwise
valueless. We will initially assume that each old person starts with ` units of currency and
that no more money is added to the system thereafter. The presence of money opens up new
trade possibilities since the initial old could exchange this money for consumption, and the
initial young could purchase this money and use it to buy consumption when they are old,
and so forth. A monetary equilibrium is one in which there a valued money supply (money
has a positive value in equilibrium). We will dene the price of a unit of the good at time
t as j
t
. but typically nd it more convenient to work in terms of its inverse, the value of a
unit of money in terms of the consumption good in that period,
t
= 1,j
t
. The reason for
this is that having money be valueless,
t
= 0. is very simple under this representation.
Because at money is intrinsically useless, it will only have value today if people think
that it will have value in the future. As a result, one of the equilibria of our model will
always be a nonmonetary one in which money has no value in every period,
t
= 0 for all
t. In this case, we are simply back to autarky in which the young eat their endowment and
the old eat nothing. Moreover, we cannot have deterministic equilibria in which money has
temporary value. To see this note simply that if money was suppose to have a positive
value through period t and zero thereafter, then the young in period t would be giving up
something to in period t for nothing in period t + 1 if they sold any of their endowment for
money. Clearly they would not want to do this. Hence, money will have no value in period t.
and the value unravels going backward in time. In the same way, money cannot have 0 value
through period t and then a positive value thereafter, since a young person in period t would
be happy to give up a vanishingly small amount of his endowment in t for the entire money
stock and strictly positive consumption in period t + 1 since we are assuming l
2
(c. 0) = .
In this economy, an individual young person takes the sequence of money values
t

1
t=1
and determines how much money they wish to acquire in the rst period of their life in order
to nance consumption in the last period of their life. For future reference, it is useful here
to allow for some second period real income c
t+1
(which below will be the real value of a
transfer). With this, their budget constraints are given by
c
1;t
+
t
:
t
_
t
and
c
2;t+1
_
t+1
:
t
+ c
t
These two constraint can be combined to form the present value budget constraint
c
1;t
+
_

t

t+1
_
c
2;t+1
_ +
_

t

t+1
_
c
t+1
12
which show the feasible set of consumptions that they can acquire given the value of money.
The key thing to note here is that the inverse of the return on money,
t
,
t+1
determines the
price of (or discount rate for) second period consumption in terms of rst period consumption
as well as income (i.e. here our transfer c
t
).
Remark 5 Let 1 = +
_
vt
v
t+1
_
c
t+1
denote the present value of income for the individual.
Then the individuals problem can be written as
max
c
1t
l
_
c
1t
. [1 c
1t
]
_

t+1

t
__
.
The rst-order condition is
l
1
l
2
_

t+1

t
_
= 0.
and hence that
l
1
l
2
=
_

t+1

t
_
.
Because preferences are homothetic, the ratio of the marginal utilities depends on the ratio
of the consumptions c
1t
,c
2t+1
. Hence, this ratio is independent of scale and depends only the
return on money
t+1
,
t
.
The fact that the ratio of consumptions is independent of scale and depends only on the
level (present value) of output. This implies consumption must be proportional to
t
and
the ratio depends upon the return. Hence, there exists an /(
t+1
,
t
) such that
c
1t
=
t
+ /(
t+1
,
t
).
which implies that
c
2t+1
=
t
+ [1 /(
t+1
,
t
)] (
t+1
,
t
).
Note that
c
1t
c
2t+1
=
/(
t+1
,
t
)
[1 /(
t+1
,
t
)] (
t+1
,
t
)
which is independent of
t
.
The real money balances of a young person in period t.
t
is given by

t
=
t
:
t
.
For the individuals rst period (of their lives) budget constraint it follows that
t
=
t
c
1t
.
and from the second period (of their lives) budget constraint, it follows that c
2t+1
=
t

t+1
,
t
.
Hence, we can just as easily think about the individuals choice problem in terms of their
real money balances. In this case, their choice problem becomes
max
qt
l(
t

t
.

t+1

t

t
)
=
l
1
l
2
=

t+1

t
.
13
This is exactly the condition we derived earlier. For the same logic as in the remark, this
implies that the optimal choice of real balances (and implicitly rst and second period
consumption) is determined solely by the rate of return on money.
Note that if the return on money is a constant 1. then
l
1
(
t

t
.
v
t+1
vt

t
)
l
2
(
t

t
.
v
t+1
vt

t
)
=

t+1

t
= 1.
Given our assumption that preferences are homothetic this implies that if the return on
money is constant, then the optimal choices of the individuals at each point in time will
imply that

t
v
t+1
vt

t
=
c
1t
c
2t+1
is a constant independent of t (and particularly the level of income
t
). For this to be true,

t
must also be proportionate to
t
. 1: fact, it follows from our earlier results that

t
= [1 /(
t+1
,
t
)]
t
Hence, individuals income elasticity of money demand is 1 (a doubling of
t
doubles
t
holding xed the return on money). At the same time the function / and in particular
/
0
, [1 /] determines the interest elasticity (or sensitivity) of money demand.
An equilibrium in our economy can be dened as a sequence of real balances
t

1
t=1
and
values of money
t

1
t=1
such that
1. Given
t

1
t=1
and for each t.
t
is a solution to the optimal choice problem of an
individual born in period t.
2. Markets clear
`
t

t
=
t
`
t
for all t = 1. 2. .... .
In much of what follows, we will restrict attention to stationary equilibria, where by
stationary we mean that the return on money is a constant. Note that the real demand for
money cannot be a constant over time if the level of population is growing (i.e. : 0) since
this will imply that the total demand for money is growing, or if
t
is growing (i.e. q 0)
since this will imply that
t
is growing since this will imply that the individual demand for
money is growing. (More on this below.)
In a stationary equilibrium with a constant money stock `. it must be the case that
supply is equal to demand, or
`
t

t
=
t
`.
Since we are assuming that the return on money,
t+1
,
t
, is constant, it follows that
t
=
/(
t+1
,
t
)
t
. Making this substitution we get that

t
=
`
t
/(
t+1
,
t
)
t
`
=
(1 + :)
t1
`
1
(1 + q)
t1
[1 /(
t+1
,
t
)]
`
.
14
From this it follows that

t+1

t
=
(1 + :)
t
(1 + q)
t
(1 + :)
t1
(1 + q)
t1
= (1 + :)(1 + q).
where we have made use of our conjecture that
t+1
,
t
was a constant to cancel out the
terms /(
t+1
,
t
) and /(
t+2
,
t+1
). This result veries the conjecture, and shows that the
return on money in a stationary equilibrium is given by the growth rate in total output.
Remark 6 The system of transfer induced by money in our stationary equilibrium with a
constant money supply exactly implements the Pareto improving transfer scheme discussed
above. Thus, the monetary equilibria is ecient. Since j
t
= 1,
t
. it follows that
j
t+1
j
t
=
_

t+1

t
_
1
=
1
(1 + :)(1 + q)
.
this ecient outcome is achieved by having the price level fall at the rate (1 + :)(1 + q). In
other words, steady persistent deation is ecient. This nding that deation is ecient is
common to a wide range of monetary models
The level of the value for money is given by

t
=
`
t

t
/([1 + :][1 + q])
`
=
1
t
1 /([1 + :][1 + q])
`
.
This shows that if the initial money supply was changed, say doubled, then the value of
money would move inversely. Note that since

t
` = `
t

t
1 /([1 + :][1 + q]) .
the real value of the money stock would be unaected by this change, as would the real
pattern of exchanges or the consumption levels of any of our individuals. This simple result
implies two stark implications:
1. The real quantity money is pinned down and hence its value moves inversely propor-
tionate to the stock of money.
2. Changes (at least to the initial stock of money) have no real eects, and this sense
money is neutral.
The rst of these implications is a simple version of the quantity theory, while second reects
the old view that the real economy was largely unaected by monetary factors.
Problem 7 Consider the following two explicit examples and derive an explicit formula for
the equilibrium levels of real balances. In so doing you will have to assume that the return on
money is constant and then determine its return, thereby verifying the conjecture. Be sure
to be explicit about these steps.
15
1. l(c
1
. c
2
) =
_
c
1
+
_
c
2
2. l(c
1
. c
2
) = log(c
1
) + log(c
2
)
Note that in example 1, we have an interest elastic demand for money - as the return
on money rises, the demand for real money rises. In example 2, the demand for money is
interest inelastic. If we assume preferences have a greater degree of curvature than log with
respect to the future good (l
22
,l
2
) then the demand for real balances would fall. This is
because even with a fall in real balances, the future value of those balances will be high
enough to lower the future marginal utility of consumption a lot because of the high degree
of curvature.
2.2.1 Aggregation
In many of our models we make a representative agent assumption, and were doing that
here in the sense that were assuming that there is a single type of agent for each generation.
To examine the consequences of this assumption, assume for a moment that instead of there
being only one level of income. For simplicity assume that a young persons income is either

H
or
L
(with
H

L
). and that the fraction with high income is given by : and the
fraction with low income is given by 1 :. and that :
H
+ (1 :)
L
= . Lets take the
value of money series from our "representative" agent economy,
t
, as given, and examine
how individual behavior would dier with dierent income levels.
The individuals problem is given by
max
mt
l(
t
.

t+1

t

t
).
=
l
1
(
i

t
.
v
t+1
vt

t
)
l
2
(
i

t
.
v
t+1
vt

t
)
=

t+1

t
for i = H. 1. Note that if the individuals preferences are homothetic, then the ratio of rst
and second period consumption is determined by the return on money. But this implies that
if we double the individuals rst period income, then his consumptions just double as well.
Hence,

i
=
_
1 /
_

t+1

t
__

i
.
and hence average money demand is given by
:
H
+ (1 :)
L
=
_
1 /
_

t+1

t
__
_
:
H
+ (1 :)
L

_
1 /
_

t+1

t
__
= .
the demand in our representative model. This is why we often neglect distributional consid-
erations.
16
3 Barter Exchange vs. Monetary Exchange
Our model of money implies that without it there is no exchange and that with it the
Pareto ecient system of transfer is implemented at no cost. Both of these implications
are products of the extreme assumptions we have made. Here we relax the model a bit
to allow the consumption good to be storable. However we complicate it to ensure that
there is still a role for money and that exchange will involve both search and search costs.
These assumptions will allow us to talk intelligently about the benets of money over barter
exchange and the costs of exchange under the two systems. In so doing, we are actually
moving our model quite close to the more modern search-theoretic models of money that are
at the frontier of current research.
We are going to assume that there are J dierent types of goods which are completely
storable across time. We are going to assume that each person is endowed with one of these
types of goods when young and nothing when old. A young person is indierent over the
type of good he consumes (or simply always likes what ever he is endowed with) while an
old person will one of the J 1 goods which he was not endowed with. We will assume
that the probably that an old person likes one of the J 1 goods is uniformly distributed.
Hence, in order to consume the good he likes, and old person must search for someone with
the good he wants. We will assume that each search costs c units of utility. We will assume
for simplicity that searching only allows you to nd other people who are also searching.
In the barter economy, a young person eats some of his own good, and then stores the
rest. When old, he must nd another old person who wants the good that he has and has
the good that he wants in order to do a simple barter exchange. The set of possible old types
out there searching are all of the possible combinations of (c. /) such that c. / 1. 2. .... J
and c ,= /. If you think of a matrix of possible combinations, the main diagonal is the only
possibility being ruled out. Hence, there are J
2
J possible types of old people searching.
This implies that the possibility of meeting someone of type (c. /) meeting someone who is
of type (/. c) so that they can undertake a simple bilateral exchange is : = 1,(J
2
J).
Let : be the number of searches until the individual had a successful match. Clearly,
: _ 1 since you cannot nd anyone without searching. This implies that the individual
undertook , = : 1 unsuccessful searches before nding his match. We are interested in
how big , is likely to be since this will determine the extent of search (or exchange) costs.
If , is equal to 0 then will think of the individual as having achieve the full information
outcome which we interpret as nding someone for sure after one search. (Thinking of it as
the cost of going to the right market but knowing which market to go to.)
1 , = 1 : 1 .
1(: 1) = 1 + Pr: = 2 + 2 + Pr: = 3 + 3 + Pr: = 4 + ...
= 1 + (1 :): + 2 + (1 :)
2
+ : + 3 + (1 :)
3
: + ...
= (1 :):
_
1 + 2 + (1 :) + 3 + (1 :)
2
+ ...

=
1 :
:
.
In deriving this expression we make use of the results in the following Remark.
17
Remark 8 We want to show that
1 + 2c + 3c
2
+ ... =
1
(1 c)
2
.
where 0 < c < 1. Let
= 1 + 2c + 3c
2
+ ...
and note that
c =
_
1 + 2c + 3c
2
+ ...

_
1c + 2c
2
+ ...

= 1 + c + c
2
+ ...
Then, note that if
r = 1 + c + c
2
+ ....
then
r cr = 1 = r =
1
1 c
.
Thus,
c =
1
1 c
= =
1
(1 c)
2
.
This implies that the expected cost of using barter is c[(J
2
J)] since the mean number
of failures is
1
1
J
2
J
1
J
2
J
= (J
2
J) 1.
In the monetary economy a young person sell some of his good for money, holds the
money until the second period, and then exchanges his money for the desired good. This
implies that the a person in the monetary economy is undertaking two searches: one when
young and one when old. However, in the rst search she is simply seeking someone who
wants the good he has (and not requiring that they also have the good he wants). Similarly,
in the second search he is simply seeking someone who has the good he wants.
Remark 9 The types of the various old people are (i. ,) for i. , 1. .... J where i ,= ,. The
probability of success for a young person searching for an old person whose second period
type ,
0
1. 2. .... J is 1,J. To see this we must rst compute the number of old people of
each type. Start rst with the fact that the fraction 1,J take on each of the possible initial
types i 1. .... J . Then, note that for any , ,= i. the odds of that young person having this
as their second period type is 1,(J 1). and 0 for type , = i. Hence, the total number of old
people whose second period type is ,
0
is given by
J

j=1
Pr (i) Pr(,
0
[i) = (J 1) +
1
J
+
1
(1 J)
=
1
J
.
The odds of success for an old person searching for a young person of type i
0
is trivially 1,J.
18
Hence the probability of success in each of these searches is 1,J. This implies that the
mean number of failures before a success in each of these searches is given by
1(: 1) =
1
1
J
1
J
= J 1.
Hence the expected search costs are given by 2cJ.
Remark 10 If J 3. then c[(J
2
J)] 2cJ. and the search costs are lower with monetary
exchange than with barter.
Modern search theoretic models of money work very similarly to this simple example.
However, the time dimension of search is much more explicitly modeled.
4 Commodity Money
Historically, at money systems, such as we have so far considered, are a recent phenomena.
The early monetary systems featured commodity money - that is a medium of exchange
which had its own inherent value. One major reason for this is that it was much easier to
get a commodity money regime going than a at one. This is because it can be very hard
to convince people that they should give up something for nothing in the vague hope that
someone else down the line will be so foolish too. Moreover, even for the U.S. initial the
money stock was backed by gold and one could turn in ones money for gold.
To a commodity money system works, assume that the initial old are with :
g
0
units of
gold, a commodity which can either be consumed or perfectly stored. Assume that this
initial endowment is the only source of gold. Assume that individuals preferences are given
by
l(c
1
. c
2
+ ~ ).
where is number of units of gold consumed and ~ is the marginal value of a unit in
consumption which we are taking to be constant here. Note that gold can only be eaten
in the second period of life. This choice will particularly relevant for the initial old whose
preferences are given by l( c
1
. c
21
+ ~ ). where c
1
is some reference parameter.
There are two types of equilibria that our model could exhibit: (i) no gold is consumed
in equilibrium, and (ii) at least some gold is consumed. We will assume that population and
output growth are zero and again restrict attention to an appropriately stationary equilibria.
If there is an equilibrium in which no gold is ever consumed, then the stock of gold will
determine the value of the money stock. To construct such an equilibrium and verify whether
or not it works we start from the individuals problem. The individuals budget constraints
are
c
1t
+
g
t
:
g
t
_
c
2t+1
_
g
t+1
:
g
t
which leads to
c
1t
+
_

g
t

g
t+1
_
c
2t+1
_ .
19
From the second period budget constraint we can think about the choice problem between
eating ones gold and which yields
max

l(c
1t
. (:
g
t
)
t+1
+ ~ ).
It is easy to see that one should eat all the gold if ~
t+1
and eat none of it if the reverse
is true. Thus ~ puts a oor on the value of gold at which time everyone will start eating it
and this will prevent the value ever going below this without gold completely disappearing.
Market clearing in each period t implies that
`
g
=
`( c
1t
)

g
t
=
g
t
=
`( c
1t
)
`
g
Stationarity will imply that c
1t
is constant, and hence that
g
t
is as well. The return on
money is 1, and if

g
t
_ ~ .
this is an equilibrium of our economy. Note that if this inequality is strict, then being used
as the medium of exchange has raised the value of gold in this economy.
If the value of good in the rst type of equilibrium is too low, then some gold will have
to be consumed in equilibrium. But this will mean that people will have to be indierent
between accepting gold and eating it. In this case,
g
t
= ~ . and the amount of money in
circulation is determined by
~ =
`( c
1
)
`
g
= `
g
=
`( c
1
)

g
t
.
Note here that it is not prices that are adjusting but the stock of circulating money. This is
the sense in which a commodity money regime can be much more stable than a at money
regime. Note that persistent ination (such as we will examine next) cannot occur here
because additions to the stock of gold will be simply consumed once we hit the lower bound
value ~ .
This result that there cannot be ination with a commodity standard is sensitive to our
assumption that there is a xed initial stock of the commodity being used as money and
that it cannot be augmented.
Problem 11 Consider allowing for growth, either through income or population growth.
Show how incorporating growth does not substantially change the analysis.
Problem 12 Assume that there was a major gold discovery at time 1. Assume that this gold
discovery came as a complete surprise. Try and use the commodity money model to discuss
what would happen. If you want to make it dicult, assume that there is also growth as in
the above problem.
20
5 Ination
In this section were going to assume that the money supply grows over time at a constant
rate,
`
t
= (1 + .)`
t1
.
This means that new units of money are being injected into the system since
`
t
`
t1
= .`
t1
.
Just as we assumed that the original units of money were given to the initial old, here we are
going to assume that the new money is given to the current old as a lump-sum transfer in
the period. (By this we mean that the amount youre given doesnt depend on your actions,
just your age.)
The individuals budget constraints are
c
1t
+
t
:
t
_
t
c
2t+1
_
t+1
[:
t
+ 1:
t+1
] .
where 1:
t+1
is the transfer of money given to each old person in period t + 1. This transfer
is
1:
t+1
=
`
t+1
`
t
`
t
.
The real value of this transfer, c
t+1
. is given by
2
c
t+1
=
t+1
1:
t+1
.
In this case, the individuals present value budget constraint can be expressed as
c
1;t
+
_

t

t+1
_
c
2;t+1
_
t
+
_

t

t+1
_
c
t+1
.
and the right hand side (r.h.s.) of this expression is the present value of his income.
If we think in terms of the real balances, then the individuals problem is to
max
mt
l(
t

t
.

t+1

t

t
+ c
t+1
).
2
For future reference, note that if the value of real balances relative to N
t
was given by
v
t+1
M
t+1
N
t
= a(1 + g)
t
;
that is, only grows with output per person and is otherwise constant, then
a
t+1
= a(1 + g)
t
a(1 + g)
t
=(1 + z)
= a [1 1=(1 + z)] (1 + g)
t
;
and hence the real transfer grows in proportionate to output and its magnitude depends upon z and the
level of a:
21
where c
t
denotes the real value of the government transfer (
t+1
1:
t+1
). This implies that an
optimal choice of real balances will satisfy
l
1
(
t

t
.
v
t+1
vt

t
+ c
t+1
)
l
2
(
t

t
.
v
t+1
vt

t
+ c
t+1
)
=

t+1

t
.
and hence the ratio

t
v
t+1
vt

t
+ c
t+1
is a constant that depends only on
t+1
,
t
. However, note that changes in the return on
money aect the relative values of the two terms in the denominator.
If we want to use our early formalism, and in particular /(). we have to be careful to
note that the earlier result was the that rst period consumption will be a fraction of the
present value of income which depends upon the return on money. Hence, we get that
c
1t
= /
_

t+1

t
__

t
+
_

t

t+1
_
c
t+1
_
.
which implies that

t
=
t
c
1t
=
t
/
_

t+1

t
__

t
+
_

t

t+1
_
c
t+1
_
=
_

t
+
_

t

t+1
_
c
t+1
_ _
1 /
_

t+1

t
__

_

t

t+1
_
c
t+1
This gives us a nice intuitive expression for money demand: his target is proportionate to
the present value of income, but we have to subtract o the present value of the second
period transfer since this gives the individual extra money holdings.
Here we need to make two conjectures which we will need to verify: (i) conjecture again
the real return on money,
t+1
,
t
. is constant over time and equal to 1. and (ii) that the level
of the real transfer per person grows with output per person 1 + q. This second conjecture
is strongly suggested by the logic in the somewhat tortuous footnote above. Note that (ii)
doesnt say that the real transfer doesnt depend upon on the level of .. just that given . its
value grows at rate q over time.
Given all this, our demand and supply condition for money,

t
`
t
=
t
`
t
can be written as

t
=
/(1)
_
(1 + q)
t1
+
1
R
c(1 + q)
t

`
t
`
t
.
where the term in brackets "[] " is simply the present value of the individuals income. From
this it follows that

t+1

t
=
(1 + :)
t
(1 + q)
t
,(1 + .)
t
(1 + :)
t1
(1 + q)
t1
,(1 + .)
t1
=
(1 + :)(1 + q)
1 + .
.
22
This veries the conjecture that the growth rate in the value of money is a constant. If the
return on money is constant, then the value of real balances for any individual will satisfy

t
= /(1)
_
(1 + q)
t1
+
1
1
c(1 + q)
t
_
and hence will be in the form of
t
= (1 + q)
t1
. That is will just grow over time at rate
q. This in turn will imply that real transfers are constant (see footnote) and hence our
conjectures are internally consistent.
Remark 13 We have shown that

t+1

t
=
(1 + :)(1 + q)
1 + .
.
which shows that money creation reduces the return on money.
This reduction in the return will lower the individuals demand for real balances or .
Hence, the pattern of young and old consumption is being aected by the introduction of
money creation. If . 0 the return on money is now below the Pareto ecient level. Hence,
if we oered a system of Pareto ecient transfers or simply an asset which grew at the
socially ecient value (1 + :)(1 + q). everyone who prefer that asset to money and society
would be better o.
Remark 14 Money is neutral here in that changes in the initial stock of money have no
real eect because they leave unchanged the return on money. Money is not super-neutral in
that changes in the growth rate of money has real eects since it changes the levels of real
balances, as well as rst and second period consumption.
One interesting aspect of introducing money is that the government now has a nontrivial
budget constraint. The government budget constraint is that the value of money creation
has to equal the value of transfers to the old, or c
t
. is such that
`
t1
c
t
= .`
t1

t
The government is raising real resources from money creation which it is giving back to
the populace. Where is this revenue coming from? To answer the rst question, assume that
in a surprise move the government didnt print any new money in period t but pledge to
continue the growth rate from t +1 onwards. In that case, the new value of money in period
t under this deviation, ~
t
. would be given by
~
t
=
`
t
/(1)
t
`
t1
= (1 + .)
t
.
Hence, this temporary change in policy would change the value of the carried over money
balances of the old. This makes clear the sense in which money creation was simply a tax
on the existing balances of the old which the government was rebating back to the old.
23
Talked about in this way, this revenue sounds costless. However the true cost of this
revenue creation is coming through the intertemporal distort in peoples consumptions
l
1
l
2
=
(1 + :)(1 + q)
1 + .
.
How much money can the government raise by this channel? To think about this mag-
nitude, start from the governments budget constraint and note that
c
t
=
.`
t1
`
t1

t
=
.
1 + .
(1 + :)
_
`
t
`
t

t
_
=
.
1 + .
(1 + :)/(1)
_
+
1
1
c(1 + q)
_
(1 + q)
t1
.
This expression is a bit of a mess, but we can see two channels by which changes in . aect
the terms:
1. An increase in . will increase .,(1 + .).
2. An increase in . will lower 1. which will decrease /(1) but increase the present value
of income via c.
It follows that c
t
= 0 if . = 0. It also follows that if . = then
t+1
,
t
= 0 and
individual will hold zero real balances since they get nothing in return. Hence c
t
= 0 if
. = . It follows that revenue is zero at both extremes. So at some point for high levels
of ination the negative term must dominate the positive term, while for low levels the
reverse is true. Hence the revenue from ination, commonly called seigniorage, is bounded
and the magnitude of this bound will depend on the sensitivity of money demand to its
return. Beyond this we need to make explicit assumptions about the interest elasticity of
real balances to the return on money to say more.
Problem 15 Assume that l(c
1
. c
2
) = log(c
1
) + log(c
2
). and derive and expression for /.
Use this result to explicitly characterize the equilibrium as a function of :. q and ..
Problem 16 Assume that . 0. and discuss how we could implement a Pareto improving
set of transfers in which the young in period t contribute
t
to be divided up among the old,

t+1
=
t
(1 + q)(1 + :). Assume that
1
is small so that
l
1
l
2
< (1 + :)(1 + q).
Discuss how the presence of these transfers will eect the competitive equilibrium of our
model. In particular, what happens to the real return on money and the level of real balances?
24
6 Money Growth, Ination and Output
There are two concerns about the interaction between money, prices and output. The rst
is what happens over the long-term, and the second is what happens over the short term.
An example of a long-term question would be: How will prices and output be dierent
over the next ten years if the growth rate of money is 5% as opposed to 10%?
An example of a short-term question would be: What will happen over the next year if
we decreased the rate of growth of money from 10% to 5%?
In the rst question there are no issues of expectation adjustment, since presumably
everyone will learn over this period what the growth rate of money is. Similarly, there are
no adjustment costs or delays. However, in the short-term we have to worry about all of
these things and they can eect the answer one expects to get.
The article by McCandless and Weber lays out three long run facts about the relationship
between money growth, prices and output. They used a broad set of countries and many
periods because they were concerned about how the specic details of the Central Banks
policy function might impact on their answer. For example, during certain periods/countries
the Central Bank targets the money supply, the ination rate or the exchange rate. Also,
it may operate by choosing the growth rate of the monetary base, the overnight interest
rate on interbank lending, or the exchange rate. The hope is that by having many dierent
observations of the long-run relationship, we will nd the facts that are independent of the
central banks policies beyond their choice of the growth rate of money.
There three main facts are:
1. The correlation between the growth rate of money and ination is very close to 1.
2. There is no correlation between the growth rate of money and the growth rate of output
in the overall sample.
3. There is no correlation between ination and output.
To organize our thinking about these facts, we use the old velocity equation:
11 = `.
where 1 is the price level, 1 is real output, ` is the money supply and is the income
velocity of money. The idea here is that denotes the number of times that money must
on average turn over if we are nancing nominal expenditures 11 with money `. Note
that in actuality, money may turn over more or less than this depending upon the pattern
of transactions and whether money is the sole medium of exchange (as opposed to credit
cards).
Fact 1 does not say that the growth rate of money is equal to the rate of ination. Just
that the correlation is near 1. Part of the reason for this is that velocity is changing over
time with technology. Examples include ATMs and the increased use of credit cards. If we
take logs and dierentiate this equation we get that
j + = d log() + :.
25
where "lower case" refer to growth rates. From this expression, we can see that if and 1 are
growing at independent rates across countries, then this simple quantity equation predicts
that the correlation of the percentage change or growth rate in j and : is one. If d log()
or are slightly eected by :. or if : is being chosen in response to these variables, this
could lead to a dierent answer.
The classical dichotomy was that money eected nominal variables while real variables
were eected by real factors. Facts 2 & 3 suggest that this assumption is largely correct over
long time periods.
A second major concern with the behavior of the price level and output is when prices
decline. There is a wide spread belief that deation can hurt output and even lead to a
depression. The paper by Atkeson and Kehoe examines this relationship over a variety of
episodes. Their main nding is that there seems to have been a link between deation and
output only during the 1930s. Overall, the recent evidence suggests that deation is pretty
bad for output, while the older evidence suggests that it is not. One reason for this dierence
is that with at money systems, zero-to-negative ination seems to only come about during
periods when the central bank is trying to stimulate the economy by lowering the interest
rate. However, this low interest rate regime, while thought to stimulate investment in the
short run, is consistent in the long-run with lowination via the Fisher relationship: i = :+:.
26