Contents

1 Money Demand (and some Supply) 4

1.1 Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2 Overview of Money Demand . . . . . . . . . . . . . . . . . . . . . . 4
Lecture Notes for Macro 2 2001 (first year PhD 1.3 Money Demand: A General Equilibrium Model with Money in the
Utility Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
course in Stockholm) 1.4 The Mechanics of Money Supply∗ . . . . . . . . . . . . . . . . . . . 16

2 The Price of Money 24

Paul Söderlind1
2.1 UIP, Fisher Equation, and the Expectations Hypothesis of the Yield
Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
June 2001 (some typos corrected later)
2.2 The Price Level as an Asset Price: Cagan’s (1956) Model with Ratio-
nal Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.3 A Simple Model of Exchange Rate Determination . . . . . . . . . . . 31

A Derivations of the Pricing Relations 38

A.1 A Real Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
A.2 A Nominal Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
A.3 A Nominal Foreign Bond . . . . . . . . . . . . . . . . . . . . . . . . 41
A.4 Real Effects of Money? . . . . . . . . . . . . . . . . . . . . . . . . . 41
A.5 Empirical Evidence on the Pricing Relations . . . . . . . . . . . . . . 42

3 Money and Sticky Prices: A First Look 45

3.1 Basic Models of the Effects of Monetary Policy Surprises . . . . . . . 45
3.2 “Money and Wage Contracts in an Optimizing Model of the Business
Cycle,” by Benassy . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
1
University of St. Gallen and CEPR. Address: s/bf-HSG, Rosenbergstrasse 52, CH-9000 St.
3.3 “Money and the Business Cycle,” by Cooley and Hansen . . . . . . . 56
Gallen, Switzerland. E-mail: Paul.Soderlind@unisg.ch. Document name: MacAll.TeX.

1
 3.4 X Sticky Wages or Sticky Prices? . . . . . . . . . . . . . . . . . . . . 61 0.3 Money and Prices in RBC Models . . . . . . . . . . . . . . . . . . . 124
0.4 Money and Monopolistic Competition . . . . . . . . . . . . . . . . . 124
4 Money in Models of Monopolistic Competition 63 0.5 Sticky Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
4.1 Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . 63 0.6 Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
0.7 Empirical Measures of the Effect of Money on Output . . . . . . . . . 126
5 Money and Price Setting 69
0.8 The Transmission Mechanism from Monetary Policy to Output . . . . 126
5.1 Dynamic Models of Sticky Prices . . . . . . . . . . . . . . . . . . . 69
5.2 Aggregation of One-Sided Ss Rule: A Counter-Example to 1M →
1Y ∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

A Summary of Solution Method for Linear RE Models 81

A.1 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
A.2 Special Case: Scalar Second Order Equation . . . . . . . . . . . . . . 82
A.3 An Alternative for the Scalar Second Order Equation: The Factoriza-
tion Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

B Calvo’s Model: An Alternative Derivation 85

6 Monetary Policy 88
6.1 The IS-LM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
6.2 The Barro-Gordon Model . . . . . . . . . . . . . . . . . . . . . . . . 91
6.3 Recent Models for Studying Monetary Policy . . . . . . . . . . . . . 97

A Derivations of the Aggregate Demand Equation 104

7 Empirical Measures of the Effect of Money on Output 106

7.1 Some Stylized Facts about Money, Prices, and Exchange Rates . . . . 106
7.2 Early Studies of the Effect of Money on Output . . . . . . . . . . . . 107
7.3 Early Monetarist Studies of the Effect of Money on Output . . . . . . 108
7.4 Unanticipated or Anticipated Money∗ . . . . . . . . . . . . . . . . . 115
7.5 VAR Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
7.6 Structural Models of Monetary Policy . . . . . . . . . . . . . . . . . 119

0 Reading List 123

0.1 Money Supply and Demand . . . . . . . . . . . . . . . . . . . . . . 123
0.2 Price Level and Nominal Assets . . . . . . . . . . . . . . . . . . . . 123

2 3

1 Money Demand (and some Supply)
Main references: Romer (1996) (Romer), Blanchard and Fischer (1989) (BF), Obstfeldt
and Rogoff (1996) (OR), and Walsh (1998).
1.1 Money Supply
References: Burda and Wyplosz (1997) 9, OR 8.7.6 and Appendix 8B, and Mishkin
(1997).
The really short version: the central bank can control either some monetary aggregate
or an interest rate or the exchange rate. How they do that is typically not very important
for most macroeconomic questions. Still, this is discussed in Section 1.4. Why they do it,
that is, the monetary policy, is much more important—and something we will discuss at
length later.
are used in many different models, for instance as the LM curve is IS-LM models. Mt in
(1.1) is often a money aggregate like M1 or M3. In most of the models on this course, we
will assume that the central bank have control over this aggregate.
1.2.3 Money Demand and Monetary Policy
There are many different models for why money is used. The common feature of these
models is that they all generate something pretty close to (1.1). But why is this broader
money aggregate related to the monetary base, which the central bank may control? Short
answer: the central bank creates a demand for narrow money by forcing banks to hold it
(reserve requirements) and by prohibiting private substitutes to narrow money (banks are
not allowed to print bills).
The idea behind central bank interventions is to affect the money supply. However,
most central banks use short interest rates as their operating target. In effect, the central
bank has monopoly over supply over narrow money which allows it to set the short interest
rate, since short debt is a very close substitute to cash. In terms of (1.1), the central bank
may set i t , which for a given output and price level determines the money supply as a
residual.

1.2 Overview of Money Demand

1.2.4 Applied money demand equations
1.2.1 Money in Macroeconomics
Reference: Goldfeld and Sichel (1990).
Roles of money: medium of exchange, unit of account, and storage of value (often domi- Applied money demand equations often take the form
nated by other assets). Mt Mt−1 Pt
Money is macro model is typically identified with currency which gives no interest. ln = b0 + b1 ln Yt + b2 i t + b3 ln + b4 ln + ut . (1.2)
Pt Pt−1 Pt−1
The liquidity service of money ( medium of exchange) is emphasized, rather than store of
where Mt is nominal money holdings, Pt the price level, Yt some measure of economic
value or unit of account.
activity, and i t the net nominal interest rate (like 0.07). The inclusion of Mt−1 /Pt−1 and
Pt /Pt−1 is thought to capture partial adjustment effects due to adjustment costs of either
1.2.2 Traditional money demand equations
nominal (b4 6 = 0) or real money balances (b4 = 0).
References: Romer 5.2, BF 4.5, OR 8.3, Burda and Wyplosz (1997) 8. For instance, the estimate for Germany (69:1-85:4) reported by Goldfeld and Sichel
The standard money demand equation (1990) is {b1 , b2 , b3 , b4 } = {0.3, −0.5, 0.7, −0.7}. (They interest rate used in their esti-
Mt mation is in percentages, that is, like 7 instead of the 0.07 used here, so I have scaled their
ln = constant + ψ ln Yt − ωi t (1.1) b2 = −0.005 by 100.)
Pt

4 5
 In general, this type of equation worked fine until 1975, overpredicted money demand we introduce leisure or credit goods.
during the late 1970s, and underpredicted money demand in the early 1980s. Financial Shopping-time models typically have a utility function is terms of consumption and
innovations? (1.2) has been refined in various ways. Various disaggregated money mea- leisure
∞
sures have been tried, a wealth of different interest rates and alternative costs have been
X
β s U (Ct , 1 − lt − n t ) , (1.5)
used, the income variable has been disaggregated, and fairly free adjustment models have s=0
been tried (error correction models). Single equation estimation of (1.2) presumes that where lt is hours worked, and n t hours spent on shopping (supposed to give disutility).
this is a true demand function, with monetary authorities setting the interest rate, and with The latter is typically modelled as some function which is increasing in consumption and
the other right hand side variables being predetermined. decreasing in cash holdings

1.2.5 Different Ways to Introduce Money in Macro Models 1.3 Money Demand: A General Equilibrium Model with Money in
Reference: OR 8.3 and Walsh (1998) 2.3 and 3.3. the Utility Function
The money in the utility function (MIU) model just postulates that real money balances
enter the utility function, so the consumer’s optimization problem is Reference: BF 4.5; OR 8.3; Walsh (1998) 2.3; and Lucas (2000)

∞  
X Mt 1.3.1 Model Setup
max∞ β t u Ct , . (1.3)
{Ct ,Mt }t=0 Pt
t=0
The consumer’s optimization problem is
One motivation for having the real balances in the utility function is that
 having cash may ∞  
shopping Mt
save time in transactions. The correct utility function would then be u Ct , L̄ − L t
X
, max∞ β t u Ct , (1.6)
{Ct ,Mt }t=0 Pt
shopping
where L t is a decreasing function of Mt /Pt . t=0

Cash-in-advance constraint (CIA) means that cash is needed to buy (some) goods, for subject to the real budget constraint
instance, consumption goods Mt Mt−1
Pt Ct ≤ Mt−1 , (1.4) K t+1 + = (1 + rt ) K t + + wt − Ct − Tt , (1.7)
Pt Pt
where Mt−1 was brought over from the end of period t − 1. Without uncertainty, this where rt is the (net) real interest rate (from investing in t − 1 and receiving the return in
restriction must hold with equality since cash pays no interest: no one would accumulate t), and wt the real wage rate. Labor supply is normalized to one. The consumer rents his
more cash than strictly needed for consumption purposes since there are better investment capital stock to competitive firms in each period. Tt denotes lump sum taxes.
opportunities. In stochastic economies, this may no longer be true. Production is given by a production function with constant returns to scale
The simple CIA constraint implies that “money demand equation” does not include
the nominal interest rate. If the utility function depends on consumption only, then all Yt = F (K t , L t ) , (1.8)
rates of inflation gives the same steady state utility. This stands in sharp contrast to the
and there is perfect competition in the product and factor markets. The firms rent capital
MIU model, where the optimal rate of inflation is minus one times the real interest rate
and labor from the households and make zero profits.
(to get zero nominal interest rate). However, this is not longer true if the cash-in-advance
I assume perfect foresight in order to simply the algebra somewhat. It is straightfor-
constraint applies only to a subset of the arguments in the utility function. For instance, if
ward to derive the same results in a stochastic setting, at least if we assume that variances

6 7
and covariances do not depend on the level of the other variables. Under perfect foresight, (1.12) can then be written
   
it Mt Mt
1.3.2 Optimal Consumption and Money Holdings = u M/P Ct , /u C Ct , , (1.14)
1 + it Pt Pt
Use (1.7) in (1.6) to get the unconstrained problem for the consumer which highlights that the nominal interest rate is the relative price of the “money services”
∞
X 
Mt−1 Mt Mt
 we get by holding money one period instead of consuming it. Note that (1.14) is a rela-
max β t u (1 + rt ) K t + + wt − Tt − K t+1 − , . (1.9) tion between real money balances, the nominal interest rate, and an activity level (here
{ K t+1 ,Mt }∞
t=0 t=0
Pt Pt Pt
consumption), which is very similar to the LM equation.
The first order condition for K t+1 is
    Example 1 (Explicit money demand equation from Cobb-Douglas/CRRA.) Let the utility
Mt Mt+1
u C Ct , = (1 + rt+1 ) βu C Ct+1 , , (1.10) function be
Pt Pt+1 "   #1−γ
Mt 1−α
 
Mt 1
which is the traditional Euler equation for real bonds (with uncertainty we need to take u Ct , = Ctα ,
Pt 1−γ Pt
the expected value of the right hand side, conditional on the information in t). It would
in which case (1.14) can be written
also hold for any other financial asset.
Mt 1 − α 1 + it
The first order condition for Mt is = Ct ,
      Pt α it
Mt Mt Mt+1 Pt
u C Ct , = u M/P Ct , + βu C Ct+1 , . (1.11) which is decreasing in i t and increasing in Ct . This is quite similar to the standard
Pt Pt Pt+1 Pt+1
money demand equation (1.1). Take logs and make a first-order Taylor expansion of
If money would not enter the utility function, then this is a special case of (1.10) since the ln [(1 + i t ) /i t ] around i ss
real gross return on money is Pt /Pt+1 . It is not obvious, however, that we get an interior
Mt 1
solution to money holdings unless money gives direct utility. ln = constant + ln Ct − it .
Pt i ss (1 + i ss )
The left hand side of (1.11) is the marginal utility lost because some resources are
taken from time t consumption, and the right hand side is the marginal utility gained by Compared with the money demand equation (1.1), ψ ln Yt is replaced by ln Ct and ω =
having more cash today and the extra consumption this allows tomorrow (cash provides 1/ [i ss (1 + i ss )]. If i ss = 5%, then ω ≈ 20, which appears to be very high compared to
utility and is also a form of saving, whose purchasing power depends on the inflation). empirical estimates.
Substitute for βu C (Ct+1 , Mt+1 /Pt+1 ) from (1.10) in (1.11) and rearrange to get
     Example 2 (Explicit money demand equation from Lucas (2000). Let the utility function
Mt 1 Pt Mt be
u C Ct , 1− = u M/P Ct , . (1.12) "  −1 #1−γ
Pt 1 + rt+1 Pt+1 Pt 
Mt

1 Ct
u Ct , = Ct 1 + B ,
The Fisher equation is Pt 1−γ Mt /Pt

Pt+1
1 + i t = Et (1 + rt+1 ) , (1.13)
Pt
where the convention is that the nominal interest rate is dated t since it is known as of t.

8 9
in which case (1.14) can be written 1.3.4 Steady State
 2
it Ct Two definitions:
= B, or
1 + it Mt /Pt
Mt

it
−1/2 • Neutrality of money: the real equilibrium is independent of the money stock.
= Ct B 1/2 ,
Pt 1 + it • Superneutrality of money: the real equilibrium is independent of the money growth
which can be written (approximately) on the same form as (1.1) rate.
Mt 1 it
ln ≈ constant + ln Ct − . Let the money growth rate be σ , so Mt /Mt−1 = 1 + σ . A steady state implies
Pt 2 i ss (1 + i ss )
that inflation, consumption, and real money balances are constant: Pt /Pt−1 = 1 + π,
This gives a value of the ω in the money demand equation (1.1) which is only half of that Ct /Ct−1 = 1, and (Mt /Pt ) / (Mt−1 /Pt−1 ) = 1. This implies that π = σ .
in Example 1. The first order condition for K , (1.10), can then be simplified as 1 + rss = 1/β.
Combining with (1.16) gives that steady state capital stock must solve
1.3.3 General Equilibrium with MIU
FK (K ss , 1) = rss
We now add a few equations to close the MIU model in a closed economy. The govern-
= 1/β − 1, (1.17)
ment budget is assumed to be in balance in every period (not restrictive since Ricardian
equivalence holds in this model) which depends only on the technology and the real discount rate, not on the money stock
Ms − Ms−1 or growth. In steady state, the capital stock is constant so Css = F (K ss , 1), so consump-
−Ts = , (1.15)
Ps tion in steady state is uniquely determined by the real side of the economy: in the steady
so the seigniorage (right hand side) is distributed as lump sum transfers (negative taxes). state of this model, money is neutral and superneutral. Note that this is not true for the
Note that this is taken as given by each individual agent. dynamics around the steady state unless marginal utility of consumption is independent
Competitive factor markets, constant returns to scale, and a fixed labor equal to one of the real money balances (see Walsh (1998) 2.3 for a textbook treatment).
(recall that is was not part of the utility function) give With a value for steady state consumption, we can solve for the steady state real money
balances, Mss /Pss , by combining the first order
∂ F (K t , 1)
rt = , and (1.16) i ss

Mss
 
Mss

∂K = u M/P Css , /u C Css , , (1.18)
∂ F (K t , 1) 1 + i ss Pss Pss
wt = F (K t , 1) − K t .
∂K
and the Fisher equation
(This follows from that w = ∂ F/∂ L and r = ∂ F/∂ K and that constant returns to scale
implies F = L∂ F/∂ L + K ∂ F/∂ K .) 1 + i = (1 + rss ) Pt+1 /Pt
In general, the price level is determined jointly with the rest of the dynamic equilib- = (1 + rss ) (1 + π ) . (1.19)
rium. In special cases, as with log utility and complete depreciation of capital (as in the
model of Bénassy (1995)) there is a closed form solution. However, in most cases, the Using (1.19) in (1.18) gives an equation in Mss /Pss and known model parameters.
equilibrium must be computed with numerical methods.

10 11
1.3.5 The Welfare Cost of Inflation Money in utility function: cost of i>3%

Fraction of consumption, %
1.5
The welfare cost of inflation is typically analyzed for the steady state, since we can then
Cobb−Douglas, α=0.99
make use of the superneutrality of money. The growth rate of money, and therefore the Lucas, B=0.0018
inflation rate and nominal interest rate, can then be changed without affecting the real 1
equilibrium.
The welfare loss from a higher nominal interest rate is often measured as the extra
consumption needed in order to achieve the same utility as in the case with lower interest 0.5
rate. The approach is typically to find the money demand function which expresses real
money balances as a function of the consumption level and the nominal interest rate M P = 0
f (i, C), and calculate utility as the value of the period utility function u [C, f (i, C)]. 3 4 5 6 7 8 9 10
If C = 1 in steady state, a certain interest rate i 0 gives the utility u 1, f i 0 , 1 . The

 Nominal interest rate, %
welfare loss from another nominal interest rate, i 1 , is the value of C which solves
h  i h  i Figure 1.1: Utility loss, in terms of consumption, of inflation in two MIU models.
u 1, f i 0 , 1 = u C, f i 1 , C . (1.20)
To get the same utility as with C = 1 and i = 3% consumption must be
This value of C is the compensation that the consumers need to be as well off with the
 1/2
interest rate i 1 as with i 0 . Note that C − 1 can be interpreted as the percentage change in 1 + B 1/2 i
1+i
consumption needed to compensate for the higher nominal interest rate. = C.
0.03 1/2


1 + B 1/2 1.03
Example 3 (Welfare loss with Cobb-Douglas/CRRA.) From Example 1, the utility at the
Figure 1.1 illustrates the result for B = 0.0018 (Lucas’ point estimate).
nominal interest rate i is
"   #1−γ Also a cash-in-advance model (see, for instance, Cooley and Hansen (1989)) can gen-
1 1 − α 1 + i 1−α
u [C, f (i, C)] = Cα C . erate welfare costs of inflation (more precise: of a non-zero nominal interest rate) if the
1−γ α i
cash-in-advance restriction applies only to a subset of the arguments in the utility func-
Consider a steady state where C = 1 and suppose that inflation is zero, so i = r . For tion. A positive inflation acts like a tax on those goods that must be paid in cash, and
instance, to get the same utility as at C = 1 and i = 3%, u [1, f (0.03, 1)], then con- thereby creates a distortion.
sumption must be
1.03/ (1 + i) 1−α
 
= C. Friedman’s Rule for Optimal Money Supply
0.03/i
Figure 1.1 illustrates the result for α = 0.99. Reference: Romer 9.8, BF 4.5.
Friedman suggested a money rate growth which would set the nominal interest rate to
Example 4 (Welfare loss from Lucas (1994).) From Example 2 we get
zero and thereby saturate money demand. The idea is that bills are (virtually) costless to
1/2 !−1 1−γ print and it has a (utility) value for agents, so why not give them as much as they would
 

1  it
u [C, f (i, C)] = C 1+ B 1/2  . possibly would like to have?
1−γ 1 + it

12 13
 We know that the steady states of the real variables is unaffected by the inflation rate 3. Some empirical evidence that really high inflation is bad for growth. It is (both
(see above), so if we concentrate attention to the steady state, then (1.14) tells us that theoretically and empirically) unclear if zero inflation is better for growth than 5%
consumers are satiated with real money balances if u M/P = 0, that is, if i = 0. inflation.
By the Fisher equation (1.13) this means that the monetary policy should set (1 + rt ) Pt+1 /Pt =
4. Seigniorage is low for most OECD countries (less than one percent of GDP, see OR
1, so the rate of deflation should equal the real interest rate. In this way, holding cash gives
8.2).
the same return as a real bond, so savers will be happy to keep large real money balances
and to get the utility out of it. 5. Low inflation means that it will be hard to drive down the real interest really low to
In steady state, inflation equals the money growth rate, so a deflation requires a shrink- stimulate output. (The nominal interest rates cannot be negative since the nominal
ing money supply, which means that seigniorage is negative—see (1.15). In this setting, return on cash is zero.).
this is compensated by lump-sum taxes, which highlights the assumption that the gov-
ernment revenues from the inflation tax is either wasted or can be raised in other, non- 6. Variable inflation may lead to large inflation surprises which redistribute wealth,
distortive, ways. If, instead, a certain revenue must be raised and the alternative taxes are increases uncertainty (affects savings in which way?), and increases the information
distortive, then it may no longer be optimal with a zero inflation rate. See Walsh (1998). costs.
If the utility function is separable in consumption and real money balances, then this
1.3.6 The Relation to Traditional Macro Models
result hold in general, not just in steady state.
Equation (1.14) is a money demand equation, which in many cases can be approximated
The Welfare Cost of Inflation - Other Arguments by
Reference: Fischer (1996), Romer 9.8, Driffil, Mizon, and Ulph (1990), and Walsh (1998) ln Mt − ln Pt = γ1 ln Ct − γ2 i t , (1.22)
4.5-4.6. which is a traditional LM equation.
When the utility function is separable in consumption and real money balances, then
1. Inflation raises the effective capital income tax (subsidy), since the nominal return the optimality condition for consumption (1.10) can often be approximated by
(loss) is taxed (part of which is just compensation for inflation). The real net of tax
return is −γ ln Ct = ln (1 + rt+1 ) + γ ln Ct+1 , (1.23)

r net = (1 − τ ) i − π
= (1 − τ ) r − τ π, (1.21)
where the Fisher relation gives i = r + E π and we assume that π = E π . This
distorts the savings decision. Some calculation for the US (Feldstein, NBER, 1996)
suggest that this effect is large (twice as large as the effect on government revenues).
Counter-argument: a lower inflation and therefore lower government revenues from
capital income taxation is likely to bring higher tax rates.
2. Costs of price adjustments and indexation.
where consumption growth is related to the real interest rate. From the Fisher equation,
we can replace ln (1 + rt+1 ) by i t −Et (ln Pt+1 − ln Pt ). This is clearly reminiscent of an
IS equation.
1.3.7 The Price Level
The price level is determined simultaneously with all other variables, and there is typically
no closed form solution.
In the special case where the utility function in (1.6) is separable, so the Euler equation
for consumption (1.10) is unaffected by real money balances, and where money supply

14 15
is exogenous is might be possible to arrive at an analytical expression for the price level. a. Interest rule
i
In this case, we can solve for the real equilibrium (consumption, real interest rates, etc) supply
without any reference to money supply. The price level can then be found by solving
(1.11) and information about money supply. This is an example of a classical dichotomy.

M
Example 5 (Solving for the price level.) Use the approximate Fisher equation, i t =Et ln Pt+1 −
b. Money rule
ln Pt + rt+1 , in the approximate money demand equation in Example 1 supply
i
1
ln Mt − ln Pt = a + ln Ct − (Et ln Pt+1 − ln Pt + rt+1 ) ,
i ss (1 + i ss )
and rewrite as
M
i ss (1 + i ss ) + 1 1 1
ln Pt = −a − ln Ct + ln Mt + rt+1 + Et ln Pt+1 , c. Mixture
i ss (1 + i ss ) i ss (1 + i ss ) i ss (1 + i ss ) i
supply
which is a forward looking difference equations for ln Pt in terms of the “exogenous”
variables ln Ct , ln Mt , and rt+1 .
M
1.4 The Mechanics of Money Supply∗

References: Burda and Wyplosz (1997) 9, OR 8.7.6 and Appendix 8B, and Mishkin Figure 1.2: Partial equilibrium on money market
(1997).
The short version: the central bank can control either some monetary aggregate or an lend at increasing interest rates. This effectively creates an upward sloping supply curve
interest rate or the exchange rate. This section is about how they do that, even if this is for the monetary base. This is illustrated in Figure 1.2.
not particularly important for most macroeconomic issues. Why they do it, that is, the
monetary policy, is much more important—and something we will return to later. 1.4.2 Money Supply and Budget Accounting

Money supply has a direct effect on government finances. Consider the consolidated gov-
1.4.1 Operating Procedures of the Central Bank
ernment sector (here interpreted as treasury plus central bank). The real budget identity
Suppose demand for the monetary base is decreasing in the nominal interest rate. Suppose is
Bt−1 Mt−1 Bt Mt
the central bank does no interventions at all. Shifts in the demand curve for money will Gt + (1 + i t−1 ) + = Tt + + , (1.24)
Pt Pt Pt Pt
then lead to movements in the nominal interest rate. Alternatively, suppose the central
where G t and Tt are real government expenditures revenues, respectively, Bt is nominal
bank announces a discount rate where any bank can lend/borrow unlimited amounts. This
debt, i t the nominal interest rate, Mt is the monetary base (the central bank liabilities),
will fix the interest rate and any shifts in the demand curve leads to movements in the
and Pt the price level.
monetary base (as the banks are free to borrow reserves and currency at the fixed rate).
Finally, it is possible to strike a compromise between these two extremes letting banks

16 17
 Assume the Fisher equation holds, so the nominal interest rate is 1.4.4 Reserve Requirements and Deposits
Pt Money stock, M, is currency, Cu, plus deposits, D, (also called “inside money” since it is
1 + i t−1 = Et−1 (1 + rt ) , (1.25)
Pt−1 generated inside the private banking system)
where rt is the real interest rate. The convention is that the nominal interest rate is dated
M = Cu + D. (1.27)
t − 1 since it is known as of t − 1. To simplify, assume rt is known in t − 1. We then get
from (1.25) that the real debt in t is Suppose that private banks (because of reserve requirements or prudence) hold the
Bt Bt−1 Pt−1 Pt Mt − Mt−1 fraction r of deposits, D, in reserves, Re. This means that an increase in reserves, 1Re,
= G t − Tt + (1 + rt ) Et−1 − . (1.26)
Pt Pt−1 Pt Pt−1 Pt allows the bank to increase deposits with the reserve multiplier, 1/r ,
Consider the case where real government expenditures and tax revenues are unaffected 1Re
1D = . (1.28)
by monetary policy (money is neutral), and where the central bank increases money sup- r
ply, Mt > Mt−1 . This drives down the real value of government debt, Bt /Pt in two These new deposits may be lent to someone (an thereby bring in profits to the bank,
ways. First, the real revenues from money creation (printing), called seigniorage, is assuming the lending rate is above the deposit rate). Note that if r goes to zero, then the
(Mt − Mt−1 )/Pt . Second, the money supply increase will probably increase the price central bank cannot control the creation of new deposits by affecting the availability of
level. If this increase is unanticipated, then actual inflation exceeds expected inflation, reserves.
Pt−1 /Pt Et−1 (Pt /Pt−1 ) < 1, so the real value of government debt brought over from t − 1 Reserve requirements mean that a private bank must hold a fraction (usually a few
decreases. percentage) of the (checkable) deposits in either cash (in the vault) or as reserves with
the central bank. This fraction is often specified as an average over some period (two
1.4.3 Money Aggregates and the Balance Sheet of the Central Bank weeks in the US). Suppose a bank needs to get more reserves (maybe depositors withdrew
The liabilities of the central bank are currency (Cu) plus banks reserves (Re) deposited money during the preceding week). It can then either sell some assets, borrow from other
in the central bank, the assets are the foreign exchange reserve, the holding of domestic banks (“federal funds” market in the US), or borrow from the central bank (at the Fed’s
bonds, and perhaps gold “discount window” in the US). Note that borrowing from the central bank is effectively
a decrease (as long as the loan lasts) in the reserve requirement. Therefore something
Balance Sheet of Central Bank has to be done to make the reserve requirements bite in spite of the possibility to borrow
Assets Liabilities from the central bank. This is typically a penalty rate for these loans, or some kind of
Domestic bonds Currency (Cu) administrative rationing of loans.
Foreign currency Reserve deposits (Re) It is the fact that r < 1 that makes banks different from other financial institutions.
Foreign bonds Net worth To see why, suppose r = 1. Then all deposits would have to be kept as reserves and
Gold couldn’t be used for lending. Consequently, any lending has to be done from the banks
own capital. In this sense, the bank is not an intermediary any more and cannot “create
money.”
The money stock deposits discussed above can be interpreted/measured in different
ways. The most common monetary aggregates are: M1 (currency, travellers’ checks,

18 19
checkable deposits); M2 (M1 plus small denomination time deposits, savings deposits,
money market funds, repos, Eurodollars); M3 (M2 plus large denomination time deposits,
and money market funds held by institutions)
1.4.5 Interventions and the Money Multiplier
The central bank can typically not control the reserves directly, only the sum of reserves
and currency (the private sector can always convert the currency into reserves and vice
versa). This sum is called the monetary base (B) (also called high-powered money, M0,
central bank money, or outside money since it is generated outside the private banking
system), is
B = Cu + Re. (1.29)
The monetary base can be increased by, for instance, an open market operation where
the central bank buys government bonds and pays by either cash (increases Cu) or cheque
(increases Re). The same effect is achieved by a foreign exchange intervention; the central
bank buys a foreign asset and pays by either cash or cheque denominated in the domestic
currency.
Suppose private agents wants to hold the fraction c of the money stock in currency.
We can then write (1.29) and (1.27) as
c is often thought of as being determined by bank/households, so the central bank can
affect money supply by either influencing r (reserve requirements) or by changing the
monetary base (interventions). The money multiplier is decreasing in fraction of currency,
c, since it acts like a “leakage” from the private banking system. At c = 0, that is, when
there is no currency, then the money multiplier is at a maximum and coincides with the
reserve multiplier.
Example 6 (US data 1994, Burda and Wyplosz (1997) 9) For the US 1994 c = 0.29,
M1/M0 = 2.83, which by (1.32) should imply that r = 0.089. The reserve requirements
on demand deposits was (at least in 1995) virtually zero for small demand deposits..
Explanations: voluntary reserves (prudence or transaction purposes) and “leakages”
(deposits in nonbank financial institutions).
Example 7 (The Great Depression.) Private sector decisions can lead to important
changes in both c and r . During the Great Depression, B was not changed much (counter
to the conventional wisdom about a contractionary monetary policy), while savers with-
drew deposits from the banks and the banks increased the voluntary reserves (both c and
r increased substantially), with the result that M decreased some 30%. Fear of banks
going bust?

B = cM + r D (1.30) Example 8 (Money creation.) The central bank makes an open market purchase of
bonds. This increases the monetary base by 1B. Recall Re = r D and Cu = cM,
M = cM + D.
so according to (1.30)  
c
The money multiplier, M divided by B, can then be written B= + r D.
1−c
M M The increase in the monetary base will therefore be split into increases in reserves and
=
B Cu + Re currency according to
D/ (1 − c)
=
Dc/ (1 − c) + r D r (1 − c)
1Re = φ1B where φ =
1 c + r (1 − c)
= . (1.31) c
c + r (1 − c) 1Cu = δ1B where δ = .
c + r (1 − c)
The relation between money stock and monetary base is therefore
For concreteness, assume this could happen if the central bank buys the bonds from the
1
M= B. (1.32) (consolidated) private bank, which in turn buys some of them from savers. The extra
c + r (1 − c)
reserves allow the (consolidated) private bank to take extra deposits. This can be done by

20 21
lending money to a customer by crediting his deposit account. This extra deposit is Burda, M., and C. Wyplosz, 1997, Macroeconomics - A European Text, Oxford University
φ Press, 2nd edn.
1D = 1B
r Cooley, T. F., and G. D. Hansen, 1989, “The Inflation Tax in a Real Business Cycle
1−c
= 1B. Model,” The American Economic Review, 79, 733–748.
c + r (1 − c)
Clearly, Driffil, J., G. E. Mizon, and A. Ulph, 1990, “Costs of Inflation,” in Benjamin M. Friedman,
and Frank H. Hahn (ed.), Handbook of Monetary Economics . , vol. 2, North-Holland.
1M = 1D + 1Cu
1 Fischer, S., 1996, “Why Are Central Banks Pursuing Long-Run Price Stability,” in
= 1B,
c + r (1 − c) Achieving Price Stability, pp. 7–34. Federal Reserve Bank of Kansas City.

as expected and all desired ratios are fulfilled (check this). Goldfeld, S. M., and D. E. Sichel, 1990, “The Demand for Money,” in Benjamin M. Fried-
mand, and Frank H. Hahn (ed.), Handbook of Monetary Economics, vol. 1, . chap. 8,
1.4.6 More on Interventions North-Holland.
Reference: OR Lucas, R. E., 2000, “Inflation and Welfare,” Econometrica, 68, 247–274.
A sterilized foreign exchange intervention is when the effects on the money supply of
a foreign exchange intervention is nullified by an open market operation; the central bank Mishkin, F. S., 1997, The Economics of Money, Banking, and Financial Markets,
buys foreign assets, pays with cash, but sell domestic assets (government bonds) to get Addison-Wesley, Reading, Massachusetts, 5th edn.
the cash back.
Obstfeldt, M., and K. Rogoff, 1996, Foundations of International Macroeconomics, MIT
An intervention on the forward market is very similar to a sterilized intervention.
Press.
Suppose the bank enters a forward contract to buy domestic currency tomorrow and to
sell foreign currency at the same time. This decreases the supply of “domestic currency Romer, D., 1996, Advanced Macroeconomics, McGraw-Hill.
tomorrow,” that is, of domestic bonds, while increasing the supply of foreign bonds - just
Walsh, C. E., 1998, Monetary Theory and Policy, MIT Press, Cambridge, Massachusetts.
like in a sterilized intervention.
It seems as if sterilized interventions can have effects on exchange rates and interest
rates, but we are not sure why. Portfolio-balance effect (changing supply changes the risk
premium, but what about Ricardian equivalence?) or signalling?

Bibliography
Bénassy, J.-P., 1995, “Money and Wage Contracts in an Optimizing Model of the Business
Cycle,” Journal of Monetary Economics, 35, 303–315.

Blanchard, O. J., and S. Fischer, 1989, Lectures on Macroeconomics, MIT Press.

22 23
 (The sign of the risk premium is just a matter of definition. Here ϕts > 0 means that
an investment in foreign bonds require a positive risk premium.) Uncovered interest rate
parity, UIP, assumes that the risk premium is zero or constant. Both (2.1) and (2.2) have
2 The Price of Money similar forms for multi-period investments.
Finally, let i t,t+s be the continuously compounded per period nominal interest rate on
Main references: Romer (1996) (Romer), Blanchard and Fischer (1989) (BF), Obstfeldt
a discount bond traded at t and maturing at t + s. The relation between long interest rates
and Rogoff (1996) (OR), and Walsh (1998).
and expected future short interest rates is
1
2.1 UIP, Fisher Equation, and the Expectations Hypothesis of the i t,t+s = (Et i t + Et i t+1 + · · · + Et i t+s−1 ) + ϕti , (2.3)
s
Yield Curve
where ϕti is a risk premium (term premium). The expectations hypothesis of interest rates
Reference: OR 8.7.1-8.7.3 (yield curve) assumes that the risk premium is zero or constant.
Derivations are given in the Appendix.
2.1.1 Pricing Relations for Nominal Returns

This section gives three very important relations, which we will use in the subsequent
analysis. These relations can be stated in several different forms, but here we use the
log-linear form which fits nicely into the linear models used in most of this class.
Let i t be a continuously compounded (per period) nominal interest rate on a discount
bond (no coupons) traded at t and maturing at t + 1, and let πt+1 = ln(Pt+1 /Pt ) be
the corresponding inflation rate. The relation between nominal interest rates, real interest
rates and expected inflation is
i t = Et πt+1 + rtr + ϕtπ , (2.1)
where rtr is a real interest rate and ϕtπ a risk premium (inflation risk premium). The Fisher
equation assumes that the risk premium is zero or constant, and sometimes also that the
real interest rate is constant.
The relation between domestic interest rates, foreign interest rates (indicated by a
star∗ ), and expected exchange rate depreciation is
2.2 The Price Level as an Asset Price: Cagan’s (1956) Model with
Rational Expectations
Reference: BF 4.7 and 5.1, Romer 9.7, OR 8.2, Walsh (1998) 4.3.
This classic model was first used to discuss hyperinflation. In this case prices are
driven almost entirely by the dynamics of money supply (Phillips effects and other influ-
ences of real variables are of minor importance). Many hyperinflation episodes originate
in the need to generate government revenues, why we will take a look at seigniorage. This
model also allows us to discuss the “asset pricing” aspect of the price level, and how to
solve such models.
The model is an approximation to the general equilibrium model with money in the
utility function, where the real side of the economy (output, consumption, real interest
rate) is kept constant.
2.2.1 Determination of the Price Level under Rational Expectations

i t − i t∗ = Et ln (St+1 /St ) − ϕts , (2.2) Suppose the money demand function (LM curve) is

where St is the exchange rate (units of domestic currency per unit of foreign currency, ln Mt − ln Pt = ψ ln Yt − ωi t , with ω > 0. (2.4)
for instance, 8 SEK per USD), and ϕts is a risk premium (exchange rate risk premium).

24 25
Prices are assumed to be completely flexible. Assume that income and the real interest Substituting for Et ln Pt+1 in (2.7) gives
rate are constant, so by the Fisher equation
ln Pt = (1 − η) ln Mt + ηEt (1 − η) ln Mt+1 + ηEt+1 ln Pt+2 ,
 
(2.8)
i t = Et (ln Pt+1 − ln Pt ) + constant,
| {z }
(2.5) ln Pt+1

= (1 − η) ln Mt + η (1 − η) Et ln Mt+1 + η2 Et ln Pt+2 , (2.9)

and the money demand equation can be normalized as
where we use the law of iterated expectations. By continuing the substitution we end up
ln Mt − ln Pt = −ω (Et ln Pt+1 − ln Pt ) . (2.6)
with
X K
These assumptions could either be motivated by that this is a steady state situation (general ln Pt = (1 − η) ηs Et ln Mt+s + η K +1 Et ln Pt+K +1 . (2.10)
equilibrium with MIU) or that we want to look at hyperinflation, where movements in the s=0
real interest rate and output are of trivial importance compared with the movements in the If lim K →∞ η K +1 Et ln Pt+K +1 = 0, then we can write
money stock. ∞
X
Remark 9 (The price of money) Note that if one unit of the good costs Pt units of money, ln Pt∗ = (1 − η) ηs Et ln Mt+s , (2.11)
s=0
then one unit of money costs Ft = 1/Pt units of goods. We can then rewrite (2.6) as
where ln Pt∗ is the “bubble-free” (or “fundamental”) solution. Note that money is neu-
ln Ft = − ln Mt + ω (Et ln Ft+1 − ln Ft ) . tral in the sense that changing the level of money supply (Mt ) by a factor γ in each
period increases the price level by the same factor. This follows from the fact that
This says that the price of money equals a dividend, − ln Mt , and a discounted capital
(1 − η) ∞ s=0 η = 1.
s
P
gain. To see that − ln Mt is like a dividend, suppose utility is U (C, M/P) = u 1 (C) +
ln M/P, then U M = 1/M. We could therefore think of − ln Mt as an approximation of Example 11 (Log money supply is random walk plus drift.) Suppose the growth rate of
the marginal utility of money. money is δ plus a (serially uncorrelated) shock, or

Rewrite (2.6) as ln Mt+1 = δ + ln Mt + εt+1 .

ln Pt = (1 − η) ln Mt + ηEt ln Pt+1 , with η = ω/ (1 + ω) < 1. (2.7) Then, the log price level in (2.11) is

The price level today depend on the money supply, but also on the expected price level ∞
X
ln Pt∗ = (1 − η) ηs (ln Mt + sδ) .
tomorrow. If the price level tomorrow is expected to be very high, then currency will
s=0
be worth little tomorrow (the value of money in terms of goods is 1/Pt ). Like any other
P∞
asset, the value of money will then decrease already today, which means that Pt increases. Since s=0 ηs s = η/ (1 − η) , the rational expectation equilibrium price level is
2

Remark 10 (Law of iterated expectations.) We must have η Mt η

ln Pt∗ = ln Mt + δ or ln ∗ = −δ ,
1−η Pt 1−η
Et Et+1 ln Pt+2 = Et ln Pt+2 ,
which we can write as (since η = ω/ (1 + ω))
since the information set in t is a subset of the information set in t + 1. (Senility is not Mt
allowed.) ln Pt∗ = ln Mt + δω or ln = −δω,
Pt∗

26 27
so the log real balances are a decreasing function of the growth rate of money. In this
special case, real money balances are not affected by the shocks. (See Romer 391-394 for
a diagrammatic description and a discussion of the case with price inertia.)
Example 12 (Log money supply is random walk plus drift, continued.) From Example
11, inflation is equal to money growth
πt = 1 ln Pt∗ = 1 ln Mt = δ + εt .
A higher growth rate of money supply δ drives up the expected inflation and therefore the
nominal interest rate (the real interest rate is assumed to be constant) which decreases
demand for real money balances. With a given money supply Mt , the price level must
increase to keep the money market in equilibrium.
Example 13 (Money supply and the nominal interest rate.) Consider a money demand
equation ln Mt − ln Pt = ψ ln Yt − ωi t , and assume that ln Yt is constant. What is the
effect on the nominal interest rate, i t , of a shock to money supply? When money supply
is a random walk, then the effect is zero, since ln Pt increases as much as ln Mt . If
ln Mt = ρ ln Mt−1 + εt with |ρ| < 1, then ln Pt = [(1 − η)/(1 − ηρ)] ln Mt so ln Pt reacts
less than ln Mt to shock. In this case, i t must decrease in response to a positive shock
to money growth. To get a positive effect on i t , the shock to money supply must be more
persistent than a random walk, for instance, by letting 1 ln Mt be an AR(1).
2.2.2 Bubbles and Saddle Point Properties
Equation (2.11) is not the unique solution, only the unique “fundamental solution.” Let
us call it ln Pt∗ , and postulate that any solution can be written as a sum of the fundamental
solution and a “bubble” bt ,
ln Pt = ln Pt∗ + bt . (2.12)
Use this in (2.7)
ln Pt∗ + bt = (1 − η) ln Mt + ηEt ln Pt+1
∗


+ bt+1 , (2.13)
and use (2.11) to obtain the requirement that any bubble must satisfy
bt = ηEt bt+1 ⇒ Et bt+s = η−s bt . (2.14)
28
Since η < 1, the expected value Et bt+s explodes.
Ruling out bubbles, that is, using the solution (2.11), therefore amounts to finding
the unique stable solution of an unstable difference equation, that is, exploiting the sad-
dle point property. Equations (2.12)-(2.14) shows that any other solution explodes (in
expectation).
2.2.3 Seigniorage
Seigniorage can be an important source of funds for the government. It has historically
been very important during specific episodes, often in conjunction with wars. (Very his-
torically, it was the fee the authorities asked for the service of minting your silver or gold.
To increase the demand for this service, it was often forbidden to mint your own coins or
to use foreign coins or even domestic coins older than a certain number of years.) The
need for seigniorage is reputed to be the main cause of most hyperinflations.
Real revenues from money creation, seigniorage, is
Mt − Mt−1
Seignioraget =
P
t 
Mt Mt−1
= 1− . (2.15)
Pt Mt
This is the real revenues the government get by printing more money. We can think of
Mt /Pt as the tax base and 1 − Mt−1 /Mt as the tax rate. In fact, seigniorage is often
called “inflation tax.” The tax rate is essentially the money growth rate, which is strongly
correlated with inflation and the nominal interest rate (the Cagan model, they are the
same). We know from the money demand equation that real balances are decreasing in
the nominal interest rate (for a given output level), so increasing the money growth rate
therefore increases the tax rate and decreases the tax base—the result is often a Laffer
curve. Mt in (2.15) should be interpreted as the monetary base. Seigniorage is fairly
unimportant for most OECD countries; it is typically less than 1% of GDP.
Example 14 From Example 11 we have
Mt = Mt−1 exp(δ + εt ), and Pt = Mt exp (δω) .
29
Use this in (2.15) to get 2.2.5 Empirical Illustrations
Mt−1 exp(δ + εt ) − Mt−1 Burda and Wyplosz (1997) Fig 8.9, 8.12, Box 8.5, Table 16.3, and Boxes 16.4-5; Walsh
Seignioraget =
Mt−1 exp(δ + εt ) exp (δω) Fig 4.3.
= exp(−δω) − exp [−δ(1 + ω) − εt ] .

This is always increasing in the money supply surprises εt , but will typically show a 2.3 A Simple Model of Exchange Rate Determination
”Laffer curve” with respect to δ.
Reference: OR 8.2.7, 8.4.1-4, Burda and Wyplosz (1997) 18-21, Isard (1995).
Example 15 (Tax smoothing and seigniorage.) Suppose the distortionary effects of taxes
are convex functions of the tax rates. The optimal way to finance government expenditures 2.3.1 UIP and the Exchange Rate Equation
is then to keep tax rates more or less constant over time. Temporary changes in govern- The traditional monetary model of exchange rates starts out from a money demand equa-
ment consumption should be met by lending/borrowing. Seigniorage is a tax, so this tion, which is combined with an UIP condition.
theory suggests that seigniorage should be relatively constant. In fact, however, seignior- The UIP (uncovered interest rate parity) condition is
age seems to much more correlated with government consumption than other taxes. War
financing is a particularly clear case. See, for instance, Walsh (1998) 4. Et 1 ln St+1 = i t − i t∗ , (2.17)

where i t and i t∗ are the (per period) domestic and foreign currency interest rates, respec-
2.2.4 Causality or Only an Equilibrium Condition?
tively, and St is the number of units of domestic currency per unit of foreign currency
In Cagan’s model, money supply is exogenous, so (2.11) shows how the expectations for (example: 8 SEK per USD). The condition says that the expected returns (measured in
money supply determine the price level. a common currency) of lending in the domestic currency or in the foreign currency are
This would no longer be true if allowed output to change and to depend on prices equal. This typically requires full capital mobility and risk neutrality.
(something we will see later in the course), or if we assumed that money supply was The money demand equation is
a function of output and inflation (something we will also see later in the course). In
this case, we could still combine the money demand equation and the Fisher equation to ln Mt − ln Pt = ψ ln Yt − ωi t , or
1
express the price level in terms of a discounted sum of expected money supply and output, i t = (ψ ln Yt − ln Mt + ln Pt ) (2.18)
ω
but it would only be an equilibrium condition.
To demonstrate the last point, suppose both the real interest rate, rt , and log output, There is a similar demand equation in the foreign country, so the interest rate differential
ln Yt , vary. Then (2.6) should be can be written
1
i t − i t∗ = ψ ln Yt − ln Yt∗ − ln Mt − ln Mt∗ + ln Pt − ln Pt∗ .




ln Mt − ψ ln Yt + ωrt − ln Pt = −ωEt (ln Pt+1 − Pt ). (2.16) ω
(2.19)

Therefore, if we replace ln Mt in (2.11) with ln Mt − ψ ln Yt + ωrt , we have a solution of The real exchange rate is defined as the relative price of foreign goods
(2.16). However, this cannot really be interpreted as the cause of the price level until we St Pt∗ “8 kronor per dollar × 1 dollar per US hamburger”
Qt = = . (2.20)
have specified how money supply, output, and the real interest rate are determined—in Pt “10 kronor per Swedish hamburger”
particular, if they depend on the price level.

30 31
You may note that the purchasing power parity (PPP) issue is about whether Q t is constant increases money demand according to (2.18); the central bank increases money supply
or not. The flexible-price monetary model of exchange rates would set Q t constant. We by either an open market operation (buying bonds, selling domestic currency) or an in-
will not impose that, so the equation for the exchange rate that we will arrive at can only tervention on the foreign exchange market (buying foreign exchange, selling domestic
by regarded as an equilibrium condition. currency). This restores money market equilibrium at an unchanged interest rate. By UIP
Use (2.20) to substitute for ln Pt −ln Pt∗ = − ln Q t +ln St in (2.19), and then combine (2.17), this is compatible with a fixed exchange rate.
with the UIP condition (2.17) to get Instead of a unilateral peg, suppose the home country and one foreign country decide
1  1 to fix their bilateral exchange rate (for instance, St = 0). According to (2.24), this puts a
Et 1 ln St+1 = ψ ln Yt − ln Yt∗ − ln Mt − ln Mt∗ − ln Q t + ln St .



(2.21) requirement on the relative money supply, Mt /Mt∗ . The level of money supply (“nominal
ω ω
anchor”) can be set to meet some other objective (the exchange rate with a third currency,
Collect the “fundamental” driving variable into
the price level, or for stabilization purposes). (This is often called the “N-1 problem.”)
vt = −ψ ln Yt − ln Yt∗ + ln Mt − ln Mt∗ + ln Q t ,



(2.22)
Example 16 (Bretton Woods.) The Bretton Woods system was originally based on the
and rewrite (2.21)as USD being pegged to gold, and the other currencies being pegged to the USD. The fixed
exchange rate forced other countries to behave according to (2.24). As a consequence, the
vt 1
Et 1 ln St+1 = − + ln St or other countries more or less adopted the US inflation rate, see (2.11). The gold peg meant
ω ω
ln St = vt + ωEt 1 ln St+1 . (2.23) that foreign central banks (not private agents) could buy gold per 35 USD per ounce.
It was expected to discipline the US since too fast US money creation would lead other
Note how the exchange rate is like any other asset: the current price is a function of some central banks to convert dollars into gold. However, this did not work as expected during
dividend, vt , plus a discounted capital gain, ωEt 1 ln St+1 . Note that (2.23) is just an the 1960s when the US money growth rate increased. Several countries, like Germany
equilibrium condition—it cannot be given a causal interpretations without making further and Japan, had strong anti-inflationary preferences but abstained from converting dollars
assumptions. into gold, possibly because of the strong political dependence of the US. At the end of the
1960s/beginning of the 1970s a series of speculative attacks toppled the Bretton Woods
2.3.2 A Fixed Exchange Rate (St fixed, Mt variable) regime.
Suppose the central bank pursues a policy of a unilateral fixed exchange rate, and that it
Example 17 (EMS.) Until the mid 1980s EMS was characterized by a series of small
manages to make this policy credible. For instance, let ln St =Et 1 ln St+1 = 0 in (2.23),
realignments, but thereafter it was very much a system for fixed exchange rates where
and note that this requires vt = 0. From (2.22), we see that this means that
most European currencies were effectively pegged to the DM. The boom in Germany after
ln Mt = ln Mt∗ + ψ ln Yt − ln Yt∗ + ln Pt − ln Pt∗ .



(2.24) the unification lead to inflationary pressure, while most other European countries were in
a fairly deep recession with almost deflationary tendencies. Bundesbank wanted to keep
If the money stock is the monetary policy instrument, then this equation shows how the monetary policy tight, which forced other countries to follow (see(2.24)). In the end, the
central bank must act to keep the exchange rate fixed. In this sense, the central bank has political pressure for looser monetary policy (for instance, in the UK) undermined the
no control over the money stock in a fixed exchange rate regime. By fixing the exchange credibility of the system and a series of speculative attacks forced a number or currencies
rate (or any other financial price) the country looses its monetary policy independence. to abandon the peg. Why? Central banks should in most cases be able to buy back the
The mechanism is the following: suppose we get a temporary shock to ln Yt . This monetary base and thereby restore the exchange rate. However, by (2.18) this would

32 33
(at unchanged prices and output) lead to very high interest rates, which may disrupt the
economy (especially the banking sector which typically borrows short and lends long).
The Swedish central bank was willing to accept extreme interest rates during the first
attack on the krona in September 1992, but not during the second attack two months later.
2.3.3 A Floating Exchange Rate
that as ω becomes large, ln St will be very similar to a martingale (for instance, a random
walk).
(2.26) gives a key role to the expectations formation. An unanticipated increase in
the fundamental will cause a large increase in ln S1 , while an anticipated increase in the
fundamental causes the exchange rate to increase already at the date of announcement. A
simple example illustrates that.

Suppose instead that the central bank lets the exchange rate move. In the extreme case,
Example 19 (Anticipated versus unanticipated shocks.) Suppose
Mt is fixed, but that is clearly not necessary for the exchange rate to move. Rearrange
(2.23) to express ln St as a function of vt and Et St+1 on the left hand side v0 = 0
vi = 1 for i ≥ 1.
ln St = vt + ωEt ln St+1 − ω ln St
If the change in vi is completely unanticipated, then
= (1 − η) vt + ηEt ln St+1 , with η = ω/ (1 + ω) < 1 (2.25)
ln S0 = 0
because ω > 0. The stable solution (ruling out bubbles) is then if E0 vi = 0 for i ≥ 1.
ln S1 = 1
∞
In contrast, if the change in vi is anticipated in t = 0, then
X
ln St = (1 − η) ηs Et vt+s . (2.26)
s=0
ln S0 = 0 + (1 − η) ∞s=1 η = η
s
P
This expresses the current exchange rate in terms of the expected values of future “divi- if E0 vi = 1 for i ≥ 1.
ln S1 = 1
dends.” This is the “asset pricing” view of exchange rate determination. Since we have
not said anything about how vt is determined, this is only an equilibrium condition. In Is often claimed that the exchange rate depreciation, 1 ln St , and the interest rate
particular, there is plenty of evidence that the real exchange rate (which is in vt ) is affected differential, i t − i t∗ , are correlated. However, this depends on which kind of shock that
by the nominal exchange rate, at least in the short to medium run. hits the economy. To get a positive correlation between 1 ln St and i t − i t∗ , the shock
must create a change in the exchange rate which is expected to be followed by changes in
Example 18 (AR(1) fundamental.) If vt+1 = ρvt + εt+1 with εt+1 iid, then Et vt+s =
the future in the same direction.
ρ s vt , so (2.26) becomes
∞
X Example 20 (A mean reverting shock to the fundamental.) When vt is iid, then (2.26)
ln St = vt (1 − η) (ηρ)s becomes
s=0
1−η ln St = (1 − η) vt ,
= vt ,
1 − ηρ so
where the last term is the effect on 1 ln St+1 of a shock to vt+1 . This effect is increasing
1 ln St = (1 − η) (vt − vt−1 ) , and
in ρ, since a larger ρ means that the shock has a more long lasting effect on vt+s .
Et 1 ln St+1 = (1 − η) Et (vt+1 − vt ) = − (1 − η) vt .
We have, once again, nominal neutrality in the sense that increasing Mt in all periods
by the factor γ increases the exchange rate with the same factor. Also note from (2.25)

34 35
Since i t − i t∗ =Et 1 ln St+1 we get The depreciation is then

Cov(1 ln St , i t − i t∗ ) = − (1 − η)2 Var (vt ) , 1 ln St = u t + (1 − η) θ0 εt − (u t−1 + (1 − η) θ0 εt−1 )

= [1 + (1 − η) θ0 ]εt − (1 − η) θ0 εt−1 ,
which is negative. It is straightforward to show that we get Cov(1 ln St , i t − i t∗ ) < 0
for any stationary AR(1) specification of vt . In contrast, most empirical estimates of this since u t − u t−1 = εt . Et εt+1 = 0, so the expected depreciation must be
covariance are positive.
Et 1 ln St+1 = − (1 − η) θ0 εt
Example 21 (Permanent shock to the level.) Consider the case when there are permanent
shocks to the level of money supply Combine to get Cov(1 ln St , i t − i t∗ ) as

vt+1 = vt + εt+1 , Cov(1 ln St , Et 1 ln St+1 ) = E{[1 + (1 − η) θ0 ]εt − (1 − η) θ0 εt−1 }{− (1 − η) θ0 εt }

= −[1 + (1 − η) θ0 ] (1 − η) θ0 Var (εt )
so (2.26) is
which can have either sign. For θ0 = 0 it is zero, since this is the random walk case
ln St = vt , discussed above. For θ0 > 0 it is always negative, since εt > 0 shifts the permanent level
1 ln St = vt − vt−1 = εt , of vt up, but also gives a temporary positive blip in t, so 1 ln St > 0 but Et 1 ln St+1 < 0.
Et ln St+1 = vt , so Et 1 ln St+1 = i t − i t∗ = 0. For θ0 < 0, we can get a positive covariance, since εt > 0 gives a temporary negative
blip, that is, the upward permanent shift in vt is not realized until t + 1. For instance, for
This means that Cov(1 ln St , i t − i t∗ ) = 0, which is still too low compared with most θ0 = −1, the covariance is η (1 − η)Var(εt ), which is positive. The basic mechanism is
empirical estimates. that the expected effect of the shock on the fundamental grows over time.

Example 22 (A more than permanent shock.) Let the fundamental be a sum of a random
2.3.4 The Correlation Between Real and Nominal Exchange Rates
walk and the shock to the random walk
A stylized fact is that the real, Q t , and the nominal, St , exchange rates are strongly posi-
vt = u t + θ0 εt , where u t = u t−1 + εt and εt is iid. tively correlated. If we assumed that St does not affect Q t , then the only explanation for
Cov(Q t , St ) > 0 in this setting is that shocks to the real exchange rate is the main driving
This means that
force behind the nominal exchange rate. As seen from (2.22) and (2.23), the nominal ex-
Et vt+s = Et u t+s + θ0 Et εt+s change rate is an increasing function of the real exchange rate. Monetary shocks should
(
u t + θ0 εt if s = 0 be small. There is plenty of empirical evidence against this view. The basic mechanism
= . would then be that monetary shocks drive St which in turn drive Q t , because nominal
ut if s ≥ 1
prices Pt∗ /Pt tend to be sticky.
By (2.26) the exchange rate is

ln St = u t + (1 − η) θ0 εt

36 37
2.3.5 Capital Controls and Risk Premia Note that the log real discount factor must be decreasing in Ct+1 (and ln Ct+1 ), since the
utility function is concave.
The preceding discussion shows that the country can chose either fixed exchange rate or j j
Let rt+1 = ln Rt+1 be the log gross return, and rewrite the first order condition as
monetary policy independence. It cannot have both, unless there is some way to break the
UIP condition (which here serves as the equilibrium condition for the capital market). One i
1 = Et exp rt+1 + qt+1 .


(A.2)
possibility of doing that is to let the central bank affect risk premia by changing the relative
supplies of different assets. For instance, the portfolio-balance approach emphasizes risk Assume that q and r j are conditionally normally distributed
premia and discusses how sterilized interventions change the risk characteristics of the " # " # " q # " q # " # " #!
qt+1 Et qt+1 εt+1 εt+1 0 σqq σq j
private-sector portfolio and thereby asset prices. Another possibility is to impose capital j = j + j with j ∼ N , .
rt+1 Et rt+1 εt+1 εt+1 0 σq j σ j j
controls, which make it costly to move capital. (A.3)

2.3.6 Other Candidate Exchange Rate Equations Example 23 (CRRA utility.) The real discount factor, q, would be normally distributed,
for instance, if ln Ct+1 and ln(Mt+1 /Pt+1 ) are normally distributed and the utility func-
There are several other candidate exchange rate equations. Monetary sticky-price models 1−γ
tion is isoelastic, so U (Ct , Mt /Pt ) = Ctα (Mt /Pt )1−α / (1 − γ ). In this case,

relaxes the assumption of instantaneous price flexibility, which often adds inflation terms
to vt and makes the real exchange rate endogenous. The Dornbusch model (see OR 9.2) qt+1 = ln[βu C (Ct+1 , Mt+1 /Pt+1 ) /UC (Ct , Mt /Pt )]
is one example.
Ct+1 (Mt+1 /Pt+1 )(1−α)(1−γ )
−αγ
Structural exchange rate equations, which try to explain exchange rates in terms of = ln −αγ
Ct (Mt /Pt )(1−α)(1−γ )
macro variables often fail to improve upon a simple random walk—at least for relatively
= −αγ ln (Ct+1 /Ct ) + (1 − α) (1 − γ ) ln(Mt+1 Pt /Pt+1 Mt ).
short horizons.
Remark 24 If x ∼ N (Ex, Var(x)), then
2.3.7 Empirical Illustrations
E exp (x) = exp [Ex + Var (x) /2] .
Burda and Wyplosz (1997) Figs. 8.9, 13.6, and 19.1; OR Figs. 9.1; Isard (1995) Figs.
3.2, 4.2, and 11.1. The distribution could be interpreted as a conditional or an unconditional distribution.

Take logs of (A.2), and apply the rule for Eexp (x) when x is normally distributed
A Derivations of the Pricing Relations  
j j
j
0 = Et rt+1 + Et qt+1 + Vart rt+1 + qt+1 /2. (A.4)
Consider an agent who chooses consumption and asset holdings optimally. Let Rt+1 be
the one-period gross return from investing in asset j in t. The first order condition is This can be written as
j 1 
j

i
1 = Et Rt+1 exp (qt+1 ) , (A.1) Et rt+1 = −Et qt+1 − Vart rt+1 + qt+1
2
1 
j
 1 
j

where qt+1 is the log real discount factor between t and t + 1. For instance, if the utility = −Et qt+1 − Vart rt+1 − Vart (qt+1 ) − Covt rt+1 , qt+1 (A.5)
2 2
function is time separable, Et 6s=0
∞ β s u(C
t+s , Mt+s /Pt+s ), then qt+1 = ln[βu C (C t+1 , Mt+1 /Pt+1 ) /UC (C t , Mt /Pt )].

38 39
The variance terms are due to the non-linear transformation (recall Jensen’s inequality) A.3 A Nominal Foreign Bond
and typically not very interesting. The covariance is more important, since it captures risk
aversion. A nominal foreign bond has also an uncertain real return, i t∗ − πt+1 + ln (St+1 /St ), since
both inflation and the exchange rate depreciation are uncertain. To see that this is the
real return, note that giving up one unit of goods today gives Pt units of domestic cur-
A.1 A Real Bond rency, and therefore Pt /St units of foreign currency. In t + 1, this gives exp i t∗ Pt /St

units of foreign currency, or exp i t∗ Pt St+1 /St units of domestic currency, and therefore


j
A real bond has a known real interest rate (it is safe), rt+1 = rtr . In this case (A.5)
exp i t∗ (Pt /Pt+1 ) (St+1 /St ) units of goods.


simplifies to
1 In this case (A.7) is
rtr = −Et qt+1 − Vart (qt+1 ) . (A.6)
2
We can use this equation to rewrite (A.5) as i t∗ − Et πt+1 + Et ln (St+1 /St ) − rtr = λt , (A.10)

j 1 
j
 
j

where the variance and covariance terms are collectively denoted λt . We can use (A.9) to
Et rt+1 − rtr = − Vart rt+1 − Covt rt+1 , qt+1 (A.7)
2 substitute for Et πt+1 + rtr to get
j
= ϕt , (A.8)
i t∗ − i t + Et ln (St+1 /St ) = ϕts , (A.11)
which shows how the expected return in excess of the safe return depends on a Jensen’s
inequality term and the covariance of the return with the stochastic discount factor. A which is the same as (2.2). It is straightforward to show that
negative covariance means that the asset tends to have an unexpectedly low return when
1
ϕts = − Vart ln (St+1 /St ) − Covt −πt+1 , ln (St+1 /St ) − Covt ln (St+1 /St ) , qt+1 .
     
marginal utility is unexpectedly high. This is like a negative insurance, so investors will 2
j
require a positive risk premium, ϕt . (A.12)
If the last covariance term is negative, then the exchange rate tend to unexpectedly ap-
preciate (the real return, measured in domestic goods, of the foreign bond is low), when
A.2 A Nominal Bond
marginal utility is unexpectedly high. Investors will then require a positive exchange rate
j
A nominal bond has an uncertain real return, rt+1 = i t − πt+1 , since inflation is uncertain. premium.
In this case (A.7) is
1 A.4 Real Effects of Money?
i t − Et πt+1 − rtr = − Vart (−πt+1 ) − Covt (−πt+1 , qt+1 ) , (A.9)
2
The derivation of the pricing relations does not rule out real effects of money. In fact, noth-
which has the same form as (2.1). Note that i t is known, so only −πt+1 enter the variance
ing has been said about how the conditional distribution (A.3) is determined: it could be
and covariance terms. If the covariance is negative, then inflation tend to be unexpectedly
the case that money supply changes affect output and therefore the optimal consumption
high (the real return on the nominal bond is unexpectedly low), when marginal utility is
decision. Alternatively, it could be the case that monetary policy cannot affect the average
unexpectedly high. Investors will then require a positive inflation risk premium. The sign
level of output, but it may have an effect on the volatilities. In this case, monetary policy
of the inflation risk premium can clearly be different in different economies. It can also
affects the risk premia for financial assets, which could affect the consumption/savings
change over time if the conditional covariance does.
trade-off.

40 41
A.5 Empirical Evidence on the Pricing Relations realignment eventually came. In many studies, the sample ended before the realignment:
the “peso problem.”) Evidence from survey data suggest that this might be the case.
Reference: Söderlind and Svensson (1997)
A.5.2 Fisher Equation
A.5.1 UIP
The Fisher equation is typically tested in much the same way as UIP: inflation is related
Several of these relations have been studied by running “ex post” regressions. For in- to the nominal interest rate and the null hypothesis is that the sum of the real interest rate
stance, to test the UIP, we could add the innovation in the log exchange rate, u t+1 = and the inflation risk premium is a constant. Most empirical evidence suggests that this is
ln St+1 −Et ln St+1 , to both sides of (2.2) to get not true, in particularly not for short maturities.

ln St+1 − ln St = i t − i t∗ + u t+1 , (A.13)

A.5.3 Expectations Hypothesis of Interest Rates
provided UIP holds, that is, if ϕts = 0. We would test this relation by running the regres-
The expectations hypothesis of interest rates is also tested in a similar way: future long
sion
interest rates are related to current long interest rates. Most evidence suggest that the
ln St+1 − ln St = a + b i t − i t∗ + εt+1 ,


(A.14)
expectations hypothesis of interest rates works fairly well for very short maturities, but
and test the null hypothesis that a = 0 and b = 1. Under the null hypothesis that UIP perhaps less well for maturities of 6 months up to a couple of years. The empirical evi-
holds, this regression should give consistent estimates of a and b, since the innovation dence for really long maturities is very mixed.
u t+1 must (by definition) be uncorrelated with the regressors, or for that matter, everything
else in period t or earlier. A.5.4 Empirical Illustrations
This testing approach is a special case of the more general implication of UIP: ln St+1 −
McCallum (1996) Fig 9.1; Söderlind and Svensson (1997) Fig 5; Söderlind (1998) Fig 2.
ln St − i t + i t∗ should be unforecastable, and therefore uncorrelated with all information
in period t.
The test of the null hypothesis is, of course, a joint test of rational expectations (that Bibliography
i t − i t∗ equals Et ln St+1 − ln St rather than some other expectation of the exchange rate
depreciation) and of no risk premia. If a 6 = 0 but b = 1, then this might (under RE) Blanchard, O. J., and S. Fischer, 1989, Lectures on Macroeconomics, MIT Press.
be interpreted as constant risk premia, which in (A.11)-(A.12) corresponds to constant Burda, M., and C. Wyplosz, 1997, Macroeconomics - A European Text, Oxford University
second moments. Press, 2nd edn.
The typical result from a large number of studies is that a 6= 0 but b 6 = 1 (often
b < 0). This could be due to time-varying risk premia (which requires time-varying Isard, P., 1995, Exchange Rate Economics, Cambridge University Press.
variances and covariances in the theory for risk premia presented above). An alternative
McCallum, B. T., 1996, International Monetary Economics, Oxford University Press,
explanation is that the sample is not long enough for ex post data to produce all the
Oxford.
jumps (devaluations) and other features that seems to be part of market expectations of
exchange rates. (The Mexican peso is the classic case, where the interest rate differential Obstfeldt, M., and K. Rogoff, 1996, Foundations of International Macroeconomics, MIT
to USD interest rates was positive for many years—and it took a very long time before the Press.

42 43
Romer, D., 1996, Advanced Macroeconomics, McGraw-Hill.

Söderlind, P., 1998, “Nominal Interest Rates as Indicators of Inflation Expectations,”

Scandinavian Journal of Economics, 100, 457–472. 3 Money and Sticky Prices: A First Look
Söderlind, P., and L. E. O. Svensson, 1997, “New Techniques to Extract Market Expecta-
Main references: Romer (1996) (Romer), Blanchard and Fischer (1989) (BF), Obstfeldt
tions from Financial Instruments,” Journal of Monetary Economics, 40, 383–420.
and Rogoff (1996) (OR), and Walsh (1998).
Walsh, C. E., 1998, Monetary Theory and Policy, MIT Press, Cambridge, Massachusetts.
3.1 Basic Models of the Effects of Monetary Policy Surprises

3.1.1 One-Period Wage Contracts

References: BF 8.2, Romer 6.8, Walsh 5.3.

The firm has a Cobb-Douglas production function so log output is

ln Yt = ln Z t + α ln K t + (1 − α) ln h t , (3.1)

where Z t is the productivity level, K t capital stock, and h t employment.

On a competitive labor market, the log nominal wage would be

ln wt = ln Pt + ln (1 − α) + ln Yt − ln h t . (3.2)

Instead, nominal wages are here set, one period in advance, equal to the expected value
of the market clearing wage (in logs, to simplify)

ln wt = Et−1 ln Pt + ln (1 − α) + Et−1 ln Yt − Et−1 ln h t . (3.3)

In period t, shocks are realized and firms employ labor until the nominal marginal
product of labor equals the nominal wage, that is, until (3.2) holds, but where is ln wt set
in t − 1. This implicitly assumes that households have a flat labor supply curve.
Use (3.3) in (3.2) to get

ln h t − Et−1 ln h t = ln Pt − Et−1 ln Pt + ln Yt − Et−1 ln Yt . (3.4)

If K t = (1 − δ) K t−1 + It , so K t is known in t − 1, then the innovation in log output is

ln Yt − Et−1 ln Yt = (ln Z t − Et−1 ln Z t ) + (1 − α) (ln h t − Et−1 ln h t ) . (3.5)

44 45
Now, use (3.4) to substitute for the labor input innovation in (3.5). After rearrangement This model is a general equilibrium model with money in the utility function, but
we get sticky nominal wages.
The key equations are:
1−α
 
1
ln Yt − Et−1 ln Yt = (ln Z t − Et−1 ln Z t ) + (ln Pt − Et−1 ln Pt ) . (3.6)
α α ∞
X 
Mt

β t ln Ct + θ ln


Utility function : E0 + V h̄ − h t (3.8)
In this model monetary policy surprises can have affect on output by causing a price Pt
t=0
surprise, while anticipated monetary policy cannot. For instance, if monetary policy could Mt wt Mt−1
Real budget constraint : Ct + + K t+1 = h t + r t K t + µt (3.9)
react to innovations in the productivity level, then it might be possible to stabilize output. Pt Pt Pt
α 1−α wt Yt Yt
Production function : Yt = Z t K t h t ⇒ = (1 − α) , rt = α . (3.10)
Pt ht Kt
3.1.2 Lucas’s Model of the Phillips Curve
Capital accumulation : complete depreciation, Yt = Ct + K t+1 . (3.11)
Reference: BF 356-361, Romer 6.1-6.4, .
The Lucas model is another way to get one-period effects of monetary supply shocks. This is the same model as in Long and Plosser (1983), but with money in the utility
The basic mechanism is that firm i has the supply curve function. The notation is standard, except that the nominal value in the beginning of t
of money is µt Mt−1 , where µt may be different from unity. Benassy refers to µt as a
1
yi = ( pi − Ei p) , (3.7) “multiplicative monetary shock.” One possible interpretation is a stochastic tax/subsidy
φ
on cash holdings, where the government prints (µt − 1)Mt−1 new money at the beginning
where pi is the firm’s price, and Ei p the expectation about the general price level based of period t and distributes it as “interest rate payments” on cash holdings. The exact
on the information set of firm i. It is assumed that firm i observes only pi and yi and uses details might not be too important. The essential feature is that there is a stochastic money
these to infer the general price level. The firm cannot distinguish between real shocks supply.
(to the relative price, pi − p) and nominal shocks. It therefore reacts, to some extent,
to all observed movements in pi : we get real effects of monetary policy as long as the 3.2.2 Flexible Prices
policy surprise lasts - the macro implication is very similar to the sticky wage model (3.6).
However, the coefficient in front of the innovation in prices here depends on the volatility The Lagrangian is
of prices, rather than on the production function parameter. ∞
X  
Mt wt Mt−1

β t ln Ct + θ ln Mt /Pt + V h̄ − h t + λt −Ct − − K t+1 + h t + rt K t + µt .


A major criticism against the Lucas model is that the misperception story is weak: the E0
Pt Pt Pt
t=0
consumer price index is published with a very short lag. (3.12)

3.2 “Money and Wage Contracts in an Optimizing Model of the Busi-

ness Cycle,” by Benassy

3.2.1 Baseline Model

Reference: Bénassy (1995), Walsh 5.3.

46 47
The first order conditions are which shows that a stable solution (with limT →∞ (αβ)T Et K T +1 /C T = 0) must satisfy
1 αβ K t+1
Ct : − λt = 0 (3.13) = ,
Ct 1 − αβ Ct
wt
h t : −V 0 h̄ − h t + λt Yt − C t


=0 (3.14) =
Pt Ct
K t+1 : −λt + βEt λt+1rt+1 = 0 (3.15) Yt
= − 1, (3.18)
θ 1 λt+1 µt+1 Ct
Mt : − λt + βEt = 0. (3.16)
Mt Pt Pt+1
that is, the Long-Plosser solution
To determine consumption, use (3.13) in (3.15)
Ct = (1 − αβ) Yt (3.19)
1 rt+1
= βEt , K t+1 = αβYt . (3.20)
Ct Ct+1
1 αYt+1
= βEt /*rt+1 = αYt+1 /K t+1 */ To determine labor supply, use (3.13) in (3.14)
Ct Ct+1 K t+1
K t+1 α (Ct+1 + K t+2 ) 1 wt
= βEt V 0 h̄ − h t = ,


/* × K t+1 , use Yt+1 = Ct+1 + K t+2 */ (3.21)
Ct Ct+1 Ct Pt
K t+1 K t+2
= αβ + αβEt . (3.17) and then note that wt /Pt = (1 − α) Yt / h t , which together with (3.19) gives
Ct Ct+1
1−α
h t V 0 h̄ − h t = ,


Note that we have used som aggregate relations (equilibrium rental rate and aggregate (3.22)
1 − αβ
resource constraint), which makes a lot of sense once we realize that tthe behaviour of a
representative agent must be compatible with equilibrium. which is an implicit function for h t . Clearly, labor supply is a constant, which we de-
Solve (3.17) recursively forward note by h (ruling out any odd V function which would make the left hand side of (3.22)
  constant in spite of changes in h t ). Note that this implies that the dynamics of log output
K t+1 K t+3
= αβ + αβEt αβ + αβEt+1 is
Ct Ct+2
K t+3 ln Yt+1 = ln Z t+1 + α ln K t+1 + (1 − α) ln h
= αβ + (αβ) + (αβ) Et
2 2 (3.23)
Ct+2
T = ln Z t+1 + α (ln α + ln β + ln Yt ) + (1 − α) ln h. /*K t+1 = αβYt */ (3.24)
X K T +1
= αβ (αβ)s + (αβ)T Et ,
CT Solving this equation recursively backwards shows that only shocks to Z t drive output:
s=0
monetary shocks do not matter for real variables. The reason is that the marginal utility
of consumption/leisure does not depend on the real money balances: the utility function
is separable. Therefore, money is neutral both in the steady state (as in most models with
money in the utility function) and along the adjustment path to steady state.
Since labor supply is constant, it is clear from the production function (3.10) that the
real wage and output have a correlation of one.

48 49
 Finally, to determine the price level, use (3.13) in (3.16) condition with respect to Bt+1 is
θ µt+1 1 λt λt+1 1 λt+1 /λt Ct /Ct+1
+ Et β = − + β (1 + i t ) Et = 0, or = βEt = βEt . (3.29)
Mt Pt+1 Ct+1 Pt Ct Pt Pt+1 1 + it Pt+1 /Pt Pt+1 /Pt
Mt+1 Mt
θ + βEt = /* × Mt , Mt+1 = µt Mt */, (3.25) We can also note that if we multiply (3.28) by Et Pt /Pt+1 , then we get
Pt+1 Ct+1 Pt Ct
1 1 1
where the second line uses the fact that money demand, Mt+1 , equals money supply, Et = βEt Ct /Ct+1 Et , (3.30)
1 + rtr Pt+1 /Pt Pt+1 /Pt
µt+1 Mt . Solving recursively forward shows that a stable solution must be
which looks pretty much like the nominal interest rate in (3.29). The difference is, of
Mt θ
= . (3.26) course, the risk inflation premium, that is, the conditional covariance of the numerator
Pt Ct 1−β
and denominator in the last term of (3.29). (Recall that E x y = E x E y + Cov (x, y).)
Equation (3.26) shows that, as long as money supply is exogenous, prices and con- This is a Fisher equation plus an inflation risk premium.
sumption are negatively correlated. The reason is that money has no effect on real vari-
ables in this model with flexible prices. Formally, we have 3.2.4 Discussion of the Money Demand Equation

Cov (ln Pt , ln Ct ) = Cov (ln Mt − ln Ct , ln Ct ) /*from (3.26)*/ The money demand equation (3.26) looks a bit odd, since it does not include the nominal
= Cov (ln Mt , ln Ct ) − Var (ln Ct ) , (3.27) interest rate. This section shows that this comes from the “dividends” payed to holders
of cash. To see this, add a lump sum transfer to the budget constraint (3.9), and assume
which is negative since Cov(ln Mt , ln Ct ) = 0 as long as Mt is uncorrelated with Z t (and that money supply evolves as, Mt+1 = σt+1 Mt . If σt+1 6 = µt+1 , then the central bank
hence output and consumption). The intuition for this result is that ln Pt is affected by balances its budget by changing the lump sum transfer.
both nominal and real shocks, while ln Ct is affected by real shocks only. It is clear from The first order condition for money holdings is then still characterized by (3.13) and
(3.26) that real shocks must drive prices and consumption in different directions, since (3.16). The first line in (3.25) still holds, but the second does not. To see what we get
the money stock is unaffected by these shocks. instead, suppose µt+1 and σt+1 are known in t. In this case, by multiplying the first line
in (3.25) by Pt Ct we have
3.2.3 Asset Pricing
Pt Ct Pt Ct
r

r r θ + µt+1 Et β = 1. (3.31)
Add a real bond to the budget constraint: add 1 + rt−1 Bt to the revenues and Bt+1 to Mt Pt+1 Ct+1
r
the expenditures. Since the real interest rate rt is known in t, the first order condition with
By using the nominal interest rate from (3.29), (3.31) can be written
r
respect to Bt+1 is
Pt Ct µt+1
1 θ + = 1. (3.32)
−λt + β 1 + rtr


Et λt+1 = 0, or = βEt λt+1 /λt = βEt Ct /Ct+1 . (3.28) Mt 1 + it
1 + rtr
This shows that when µt+1 is proportional to 1 + i t , then we get a quantity equation. This
We could also add a nominal bond to the budget constraint: add (1 + i t−1 ) Bt /Pt is satisfied when Mt+1 = µt+1 M, since by combining (3.26) and (3.29) we also see that
to the revenues and Bt+1 /Pt to the expenditures. Since i t is known in t, the first order 1 + i t = Mt+1 /(Mt β) = µt+1 /β. It can be noted that the nominal interest rate must be
higher than the direct dividends on cash to compensate for the fact that cash has a direct

50 51
effect on utility. Otherwise no one would like to buy nominal bonds.
In most monetary macro models, the dividend on money is not proportional to the
nominal interest rate. To demonstrate this, consider the very simple case where (i) cash
has do dividends (µt+1 = 1 in all periods); (ii) consumption and the real interest rates
are constant (more generally, they follow an exogenous process since they are unaffected
by money supply); (iii) the Fisher equation holds; (iv) and money supply follows some
stochastic process. This is Cagan’s model, where we easily can generate movements in
the nominal interest rates by making money supply something other than a random walk.
Even if the nominal interest rate cancels from the money demand equation, it is not
obvious it should simplify to a quantity equation. It is straightforward to show that this
happens only when the utility function has a Cobb-Douglas form or logarithmic form in
terms of consumption and real money balances.
3.2.5 Nominal Wage Contracts
Assume now that nominal wages for t are set in t − 1, with the agreement that households
will supply any labor actually demanded by firms in t (compare with the “right to manage”
in the wage literature). The log nominal wage is set equal to the log expected (as of t − 1)
nominal value of the marginal product of labor in t in the case of no stickiness. This
assumption is, of course, ad hoc but not too unreasonable—and very convenient.
The household still optimizes (3.12), but it now takes h t as given. Since the utility
function is separable, the first order conditions for Ct , K t+1 , and Mt are unchanged.
To find the wage, note that from the production function we have wt = Pt (1 − α) Yt / h t ,
which we rewrite as
wt = Pt (1 − α)
Ct 1
/*Yt = Ct / (1 − αβ) from (3.19)*/
1 − αβ h t
(1 − α) (1 − β) 1 1−β
= Mt . /*Pt Ct = Mt from (3.26)*/ (3.33)
θ (1 − αβ) h t θ
Since h t = h with flexible prices, the log nominal wage set in t − 1 is
ln wt = Et−1 ln Mt + constant. (3.34)
52
Use (3.34) in (3.33) to solve for h t
ln h t = ln Mt − Et−1 ln Mt + constant. (3.35)
Combining this with (3.24), but replacing h with h t+1 gives
ln Yt+1 = ln Z t+1 + α ln Yt + (1 − α) (ln Mt+1 − Et ln Mt+1 ) + constant, (3.36)
which shows that money supply surprises affect current output. It also affects future
output via capital accumulation.
Since labor supply is now positively correlated with output, real wages are no longer
perfectly correlated with output.
Since consumption and output are positively correlated with money supply, the corre-
lation between prices and output does not have to be negative, see (3.27). Note that ln Mt
equals ln Pt + ln Ct plus a constant. Since real shocks have no effect on ln Mt they must
move ln Ct and ln Pt in opposite directions. In contrast, nominal shocks move both ln Mt
and ln Ct in the same directions, but ln Ct moves less (see (3.36)), so ln Pt also moves in
the same direction. The covariance of ln Ct and ln Pt is an average of these two forces -
and depends therefore on the relative volatility of real and nominal shocks.
Example 25 (Correlation of output and real wage in a special case.) Suppose α = 0 (or
that K t is very stable so it doesn’t matter for the business cycle movements). By using the
definitions in (3.10), Yt = Z t h t and wt /Pt = Yt / h t = Z t , we then get

wt

Cov ln Yt , ln = Cov (ln Z t + ln h t , ln Z t )
Pt
= Var (ln Z t ) ,
since (3.35) shows that ln h t depends only on money supply shocks, which are assumed to
53
be uncorrelated with the productivity level. The correlation is therefore labour supply in t exactly offsets the increased propensity to consume so investment is
unaffected by the shock to At .
Cov ln Yt , ln wPtt
 
wt
 
It is also possible to think of direct shock to labour supply (add a stochastic parameter
Corr ln Yt , ln =
Std ln wt Std (ln Y )
 
Pt in the V function) or to money demand (let θ be stochastic). Shock to labour supply will
Pt t

Var (ln Z t ) certainly affect output and prices, but shocks to money demand will (under flexible prices)
=
Std (ln Z t ) ∗ Var (ln Z t ) + Var (ln Mt − Et−1 ln Mt )
 1/2 probably not affect the real side of the economy since the utility function is separable.
1
= 1/2 3.2.7 Extensions of the Model: Monetary Policy
1 + Var (ln Mt − Et−1 ln Mt ) /Var (ln Z t )

which decreases towards zero as the volatility of the money supply shocks increase, and So far, monetary policy has been described as some type of random process for money
increases towards one as the volatility of the Solow residual increases. supply. In reality, monetary policy is typically pursued with a purpose: to stabilize infla-
tion or perhaps output, or even to maximize welfare.
3.2.6 Extensions of the Model: Demand Shocks With flexible prices, monetary policy can clearly not affect the real variables like
output and consumption. It can, however, affect prices. We see from (3.26) that any
This model has two shocks: to productivity and to money supply. It is easy to add demand change in Mt makes Pt change to keep Mt /Pt unchanged (recall that Ct is unaffected).
shocks, which could useful for discussing monetary policy. The easiest way to do that is This shows that the central bank can affect prices, and even control them if it can set Mt
to change the utility function (3.8) by multiplying ln Ct with a random taste parameter, after the productivity shock is realized, but that this does not affect utility (none of the
At . In this case, the first order condition for optimal consumption (3.13) becomes arguments in the utility function—Ct , Mt /Pt , and h t —is affected).
This is no longer true when there is nominal stickiness, provided monetary policy can
At /Ct = λt . (3.37)
surprise private agents. Note from (3.36) that monetary policy surprise have real effects.
This changes a number of things. In particular, (3.17) becomes If money supply can be set after the productivity (or demand) shock is observed, then
monetary policy can clearly stabilize output. Too see this, decompose log productivity in
At K t+1 At+1 K t+2
= αβEt At+1 + αβEt . (3.38) t + 1 into its expectation in t and the shock: ln Z t+1 = Et ln Z t+1 + εt+1
z
and do the same
Ct Ct+1
for money supply ln Mt+1 = Et ln Mt+1 + εt+1 . We can then write (3.36) as
m

Solving recursively forward, and assuming that limT →∞ (αβ)T Et A T K T +1 /C T = 0)

gives ln Yt+1 = Et ln Z t+1 + εt+1
z
+ α ln Yt + (1 − α) εt+1
m
. (3.40)
T
K t+1 X
= αβ (αβ)s Et At+1+s /At . (3.39) Suppose central bank has the policy rule
Ct
s=0
This shows how the taste parameter affects the trade-off between consuming today and εt+1
m z
= −εt+1 /(1 − α), (3.41)
investing in capital for future consumption. For instance, if the current taste parameter is
higher than expected future taste parameters, At > Et At+1+s , then K t+1 /Ct is lower than then log output is
otherwise. This means that consumption is higher. ln Yt+1 = Et ln Z t+1 + α ln Yt . (3.42)
Will a temporary shock to At affect output? Yes, it is likely to affect Yt if labour In this case, output can be perfectly predicted one period ahead (but not two). This cer-
supply increases (it typically will)—and yes, it will also affect Yt+s unless the increased tainly affects real variables and utility.

54 55
3.3 “Money and the Business Cycle,” by Cooley and Hansen case letters denote values for a representative household, whereas upper case letters de-
note aggregates.)
Reference: Cooley and Hansen (1995).
∞
X
Utility function : E0 β t [a ln c1t + (1 − a) ln c2t − γ h t ]
3.3.1 Stylized Facts t=0
m t+1 wt mt Tt
Hodrick-Prescott filtered data (data minus a moving average: cycles longer than 8 years Real budget constraint : c1t + c2t + xt + = h t + rt kt + + .
Pt Pt Pt Pt
are virtually eliminated).
Cash-in-advance constraint : Pt c1t = m t + Tt
Production function : Yt = e z t K tθ Ht1−θ .
Variable (xt ): Corr(xt−2 , ln GDPt ) Corr(xt , ln GDPt ) Corr(xt+2 , ln GDPt )
Capital accumulation : kt+1 = (1 − δ) kt + xt .
ln Yt 0.63 1 0.63
Government budget constraint : Tt = 1Mt+1 .
ln M1/1 ln M1 0.41 0.33/ − 0.12 0.12
ln Velocity −0.08 0.37 0.33 Money supply : 1 ln Mt+1 = 0.491 ln Mt + ξt+1 , ln ξt+1 ∼ N , known at t.
 
Nominal interest rate: −0.03 0.40 0.44 Log productivity : z t+1 = 0.95z t + t+1 , t+1 ∼ N 0, 4.9 × 10−5
Inflation: 0.01 0.34 0.44
(Note: it should be Tt /Pt in the real budget constraint; there is a typo in the book.) The
ln Price level: −0.72 −0.52 −0.17
notation is: capital stock (K ), money stock (M), price level (P), wage rate (W ), hours
Some facts: worked (H ), output (Y ), investment (X ), and productivity (z). Note that the notation
differs somewhat from the model in Bénassy (1995): the money stock held at the end of
1. Log money and log velocity (ln V = ln Y + ln P − ln M) are procyclical.
period t is denoted Mt+1 (Mt in Benassy).
(a) Log money peaks before log output (Corr(ln M1t−1 ,ln Yt ) > Corr(ln M1t ,ln Yt ) Private consumption consists of a “cash good,” c1t , and a “credit good,” c2t . One
> Corr(ln M1t+2 ,ln Yt )). interpretation of the trading sequence within a time period t is the following.

(b) Log velocity lags output. 1. In the beginning of the period, the household carries over m t from t − 1, and gets
Tt is cash transfers from the government. Households also own all physical capital
2. The nominal interest rate (short) and inflation rate are also procyclical, but peaks (kt ). Firms hold no cash or physical capital. The government finances the transfers
after output. by printing new money.

3. The log price level is counter cyclical.
3.3.2 Inflation Tax Model
This is a fairly standard real business cycle model, with some additional features. A
stochastic money supply interacts with a cash-in-advance transaction technology to cre-
ate some real effects of money supply shocks. The key equations are listed below. (Lower
2. Firms rent capital and labor (the rent and wages are paid somewhat later in the
period), and produce goods.
3. The household buys the cash good with the available cash, where the cash-in-
advance restriction Pt c1t ≤ m t + Tt must hold. (The log-normal distribution of
the money supply shock ξt means that the money stock can never decrease, which
is enough to ensure that the CIA constraint always binds: positive nominal interest
rate with probability one.) Firms now hold m t + Tt in cash.

56 57
 4. The household receives nominal factor payments wt h t + Pt rt kt from the firms (ex-
hausts all profits), and buys credit goods (Pt c2t ) and investment goods (Pt xt ). The
firms now hold no cash; households own the physical capital kt+1 = (1 − δ) kt + xt ,
and the cash m t+1 = wt h t + Pt rt kt − Pt c2t − Pt xt .
5. In equilibrium, the money stock held by the households (m t+1 ) must equal money
supply by the central bank (m t + Tt = Mt+1 ).
this is not reflected by the headers: they should read (x(+5), ..., x, ..., x(−5).)
Output is virtually neutral with respect to money supply shocks, even if the composi-
tion of aggregate demand is affected by the inflation tax. Intuition: 1 ln Mt ⇒expected
inflation⇒expensive to hold money so households substitute credit goods (and saving,
that is future consumption) for cash goods.
The following table summarizes some properties of data and simulations (simulation
results in parentheses):

Calibration
Variable (xt ): Corr(xt−2 , ln G D Pt ) Corr(xt , ln G D Pt ) Corr(xt+2 , ln G D Pt )
The parameters in the production function, depreciation, Solow residual, and time pref-
ln Yt 0.63 (0.44) 1 (1) 0.63 (0.44)
erence are chosen as in standard RBC models. The money supply process (for M1) is
ln M1/1 ln M1 0.41 (?) 0.33/ − 0.12 (?/0) 0.12 (?)
estimated with least squares. The a parameter is estimated from the first-order condition
ln Velocity −0.08 (0.48) 0.37 (0.95) 0.33 (0.35)
C1t + C2t Pt (C1t + C2t ) Pt Ct 1 1−α Nominal interest rate: −0.03 (0.01) 0.40 (-0.01) 0.44 (0.01)
= = = + *interest rate, (3.43)
C1t Pt C1t mt α α Inflation: 0.01 (-0.06) 0.34 (-0.14) 0.44 (0.04)
where the paper uses the portion of M1 held by households as a proxy for m t (this differs ln Price level: −0.72 (-0.06) −0.52 (-0.22) −0.17 (-0.16)
from how they estimate the AR(1) for money supply, where they use all of M1). Iden- 1. Correlation money growth and real variables very small (except for the correlation
tifying a from the intercept, they get a = 0.85. (If they had identified α from the slope between money and the cash good which is very negative. In data, all correlations
instead, then they would have got α = 0.9.) between real variables and money growth are small.
To sum up, they use θ = 0.4, δ = 0.019, β = 0.989, γ = 2.53, and a = 0.84.
2. Correlation output and interest rate/inflation is completely wrong.
Solving the Model
The inflation tax means that the competitive solution will not coincide with the social 3. Correlation output and velocity is much too strong.
planners’s solution. The solution algorithm is therefore a based on the concept of recursive
4. For impulse response function, see Cooley Fig 7.6.
competitive equilibrium. Solving a quadratic approximation (in logs) of the model results
in a set of linear decision rules in terms of the state of the economy. Productivity is
3.3.3 A Model with Nominal Wage Stickiness
stationary (|ρ| < 1), but the money supply is not, so prices will also be non-stationary. It
is therefore very convenient to “detrend” all nominal variables by dividing by Mt before The wage contract is based on the one-period ahead expectation of the marginal product
the solution algorithm is applied. of labor. The first order condition for profit maximization is
 θ
Kt
Results wt = (1 − θ ) Pt e z t ⇒ (3.44)
Ht
The model is simulated 100 times to generate artificial samples of 150 quarters, and the ln wt = ln (1 − θ ) + ln Pt + z t + θ (ln K t − ln Ht ) . (3.45)
simulated data is subsequently filtered with the Hodrick-Prescott filter. (Note: Tables 7.3-
It is assumed (ad hoc) that ln wt is set equal to the expectation of the right hand side of
7.5 have the x(±s) columns in the reverse order compared with Tables 7.1-7.2, even if
(3.45), conditional on the information in t − 1. Note that K t is in the information set at

58 59
 X
t − 1, while Pt , Ht , and z t are not. The deterministic steady state of the economy with 3.4 Sticky Wages or Sticky Prices?
the this type of wage contracts is the same as in the economy without wage contracts
(simplifies a lot). Reference: Romer 5.4, Mankiw’s comment to Rotemberg (1987).
The nominal wage is fixed in t − 1, and the price level is observed in t. Money The distinction between wages and prices is often blurred in models of nominal stick-
supply shocks may therefore affect the real wage by affecting the price level. Workers are iness. It is still interesting to take a quick look at the different possibilities.
assumed to supply inelastically at the going real wage (firms are on their labor demand
3.4.1 Sticky Wages and Flexible Prices
schedules). A positive money supply shock will decrease the real wage and therefore
increase labor demand and output. As usual, this effect lasts as long as some prices The combination of sticky wages, flexible prices, and an additional assumption about that
remain fixed: here it is one period since we have one-period labor contracts. Consumers the firms are on their labor demand curve means that workers have a completely elastic
(which own both the firms and the labor resources and therefore get all output) choose labor supply at the given real wage (see Keynes, Bénassy (1995), Cooley and Hansen
to consume only a fraction of the temporary income increase, so most of output increase (1995)): unemployment/overemployment. Firms hire labor until FL (L) = W/P holds,
spills over to investment (saving). so demand shocks lead to counter cyclical real wages (a demand shock increases the price
Results: level and therefore decreases the real wage which makes it profitable to hire more workers;
The following table summarizes some properties of data and simulations (with the both P and L increases so FL (L) decreases if F (L) is a concave production function).
simulation results in the parentheses). However, this implication can be overturned by assuming that the markup of prices
over marginal costs, µ, is counter-cyclical. Since nominal marginal costs is W/FL (L),
Variable (xt ): Corr(xt−2 , ln G D Pt ) Corr(xt , ln G D Pt ) Corr(xt+2 , ln G D Pt ) we have FL (L) /µ = W/P. Consider a fixed nominal wage and an increase in demand.
ln Yt 0.63 (0.20) 1 (1) 0.63 (0.20) If the markup is constant, then we have the previous case. However, if µ is lower in
ln M1/1 ln M1 0.41 (?) 0.33/ − 0.12 (?/0.61) 0.12 (?) booms (higher demand elasticities in booms because shopping around or more difficult to
ln Velocity −0.08 (0.17) 0.37 (0.98) 0.33 (0.12) sustain collusion in booms?), then prices need not increase and the real wage is constant.
Nominal interest rate: −0.03 (-0.05) 0.40 (0.48) 0.44 (0.01)
Inflation: 0.01 (-0.12) 0.34 (0.56) 0.44 (0.02) 3.4.2 Flexible Wages, Sticky Prices with Monopolistic Competition
ln Price level: −0.72 (-0.27) −0.52 (-0.01) −0.17 (-0.06) In this case, prices are fixed, but MC > P so firms are willing to supply demand (up
to where MC = P, assume this never happens), so we here assume a completely elastic
1. Much stronger correlation of 1 ln Mt and real variables than in inflation tax model
supply of goods. Labor demand is then found by inverting the production function L d =
(at odds with data).
F −1 (Y ). Workers are on their labor supply curve (no unemployment/overemployment),
2. Better fit of the contemporaneous correlation of nominal interest rate/inflation and so the real wage is given by the condition that the labor market clears L d = L s , or
ln G D Pt , but worsens the correlation of the price level and ln Yt . But the fit for F −1 (Y ) = L (W/P). A demand shock increases Y and L which requires that W/P
leads and lags still poor. increases: demand shocks lead to pro-cyclical real wages.
However, the implication of no unemployment can easily be overturned by adding
3. For impulse response function, see Cooley Fig 7.7.
real labor market frictions where there is equilibrium unemployment (efficiency wages,
insider-outsiders). A common specification is that there is a real wage function W/P =

60 61
w (L) which together with labor demand determine a real wage rate, where workers would
be willing to supply more labor.

4 Money in Models of Monopolistic Competition

Bibliography
4.1 Monopolistic Competition
Bénassy, J.-P., 1995, “Money and Wage Contracts in an Optimizing Model of the Business
Cycle,” Journal of Monetary Economics, 35, 303–315. Reference: Walsh (1998) 5.3 (See also Romer (1996) 6.6, Blanchard and Fischer (1989)
8.1, and Obstfeldt and Rogoff (1996) 10.1)
Blanchard, O. J., and S. Fischer, 1989, Lectures on Macroeconomics, MIT Press.
Background: Monopolistic competition do not, in itself, lead to a role for monetary
Cooley, T. F., and G. D. Hansen, 1995, “Money and the Business Cycle,” in Thomas F. policy—nominal stickiness does. Monopolistic competition is only a starting point for
Cooley (ed.), Frontiers of Business Cycle Research, Princeton University Press, Prince- discussing price setting behaviour.
ton, New Jersey.
4.1.1 Producers of the Final Good
Long, J. B., and C. I. Plosser, 1983, “Real Business Cycles,” Journal of Political Economy,
91, 39–69. The final good (the good that enters the utility function of agents) is produced by compet-
itive firms. The production function is a CES function (with constant returns to scale) of
Obstfeldt, M., and K. Rogoff, 1996, Foundations of International Macroeconomics, MIT
a continuum of intermediate goods Y (i), indexed by i ∈ [0, 1]
Press.
!1
Z 1 q
Romer, D., 1996, Advanced Macroeconomics, McGraw-Hill. Yt = Y (i) di
q
, 0 < q < 1. (4.1)
0
Rotemberg, J. J., 1987, “New Keynesian Microfoundations,” in Stanley Fischer (ed.),
NBER Macroeconomics Annual . pp. 69–104, NBER. Example 26 (CES production function with two inputs.) Consider the CES production
function
q q
1/q
Walsh, C. E., 1998, Monetary Theory and Policy, MIT Press, Cambridge, Massachusetts. y = x1 + x2 .

We get a linear production function, y = x1 + x2 , if q = 1; a Leontief production function,

1/2 1/2
, y = min (x1 , x2 ), if q = −∞; and a Cobb-Douglas production function, y = x1 x2 ,
if q = 0.

The price of Y (i) is P (i). Profits of a firm in the final good sector are
Z 1
π = PY − P (i) Y (i) di
0
!1
Z 1 q Z 1
=P Y (i) di q
− P (i) Y (i) di. (4.2)
0 0

62 63
 The first order condition for profit maximization with respect to input i is that the The real unit cost will depend on the productivity level (negatively), and the factor prices
(nominal) marginal product equals the price (positively, being homogenous of degree one in factor prices). The first order condition,
! 1 −1 with respect to Y (i), for profit maximization is that (nominal) marginal revenues equal
Z 1 q
1 (nominal) marginal costs
P Y (i) di
q
qY (i)q−1 = P (i)
q 0
∂ P (i) ∂Y (i)κ
q( q1 −1)
Z 1 P (i) + Y (i) = P (i) . (4.8)
PY Y (i) q−1
= P (i) /*Y = q
Y (i) di*/ or
q ∂Y (i) ∂Y (i)
0 Example 27 (Cobb Douglas production function.) Suppose the production function is
1
P (i)
 
q−1
Y (i) = Y. (4.3) Cobb-Douglas
P Y (i) = Z K (i)a L (i)b ,
Since all producers of the final good have the same production functions and their mass which has decreasing returns to scale if 1/κ = a + b < 1. The real cost function of
is one, this is also the (aggregate) demand curve for intermediate good i. producing Y (i) is
Using the demand equations in the expression for profits, (4.2), we get
1 a
w b
1
a+b
1  (i) Y (i)k = γ Z − a+b r a+b Y (i) a+b ,
1 P (i)
Z  
q−1 P
π = PY − P (i) Y di. (4.4) | {z }
0 P (i)

Divide by PY to get
q
where γ is a constant (γ = (a/b)b/(a+b) + (a/b)−a/(a+b) ). Marginal cost is increasing
π 1P
(i)

in output if there is decreasing returns to scale, 1/κ = a + b < 1.
Z q−1
=1− di (4.5)
PY 0 P
Invert the demand function (4.3)
Zero profits (there is perfect competition on the market for the final good) means that the
q−1
Y (i)

output price, P, must make the right hand side of (4.5) zero, so
P (i) = P . (4.9)
"Z # q−1 Y
1 q
q
P= P (i) q−1 di . (4.6) Use (4.7) and (4.9) in (4.8) to get
0
q−1
Y (i)

1
This expression defines the price of the final good, which we can think of as a CPI or an P (i) + Y (i) (q − 1) P = P (i) κY (i)κ−1 . (4.10)
Y Y (i)
aggregate price level.
Simplify and use (4.3) or (4.9) to substitute for Yi
4.1.2 Producers of the Intermediate Goods " 1 #κ−1
P (i)

q−1
q P (i) = P (i) κ Y or
Each of the intermediate goods is produced by a monopolist. The profits of firm i are P
  q−1
π (i) = P (i) Y (i) − P (i) Y (i)κ , κ > 1, P (i) κ q−κ q−1 (κ−1)(q−1)
(4.7) =  (i) q−κ Y q−κ . (4.11)
P q
where  (i) is the real unit cost function, 1/κ is the returns to scale in the production This is the profit maximizing choice of price for firm i. Note that the firm takes the
function (that is, the production function is assumed to be homogenous of degree 1/κ). aggregate price level (the prices of other firms) as given when setting its price.

64 65
4.1.3 Price Setting Behaviour
Firms set their prices taking other prices, P, and aggregate output, Y , as given. Changes
in the aggregate price level are clearly matched one for one. Changes in aggregate output
acts like a demand shifter for firm i, see (4.3). Suppose that Y increases, but that real
unit cost, (i), is unchanged. In this case, firm i will raise its price (the exponent of Y
is positive since 0 < q < 1 and κ > 1). For instance, if κ = 3/2 and q = 1/2 then
(4.11) becomes P (i) /P = 31/2  (i)1/2 Y 1/4 , which is increasing in Y . The intuition is
that, with decreasing returns to scale, it is too expensive for the firm to meet an increase
in demand by just increasing output. Instead, both the price and output will be increased.
This feature will be important when we analyze price setting in an environment with some
kind of costs associated with changing nominal prices.
4.1.4 General Equilibrium and Growth
This model of the production side of the economy is easily combined with a model for
household optimization. First, both consumption and accumulation of physical capital
is done in terms of the final good. Second, firms producing intermediate goods make
profits, which must be distributed to the owners (households). Third, households must
be able to buy and sell shares in the firms: we need a market for equity. Fourth, the
standard expressions for the rental rate of capital and wage rate no longer apply since
factor payments do not exhaust the value added.
This model has decreasing returns to scale, which we probably should think of as
a short-term to medium-term feature. There are two ways to fix the model in order to
fit stylized facts of long run data. The mass of intermediate goods could be allowed to
expand over time, as in many models of endogenous growth. Alternatively, we could
change the production function for intermediate firms by adding a semi-fixed production
factor which can be accumulated over time (for instance, some type of physical capital).
There could then be short-run decreasing returns to scale, but long-run constant returns to
scale.
4.1.5 Equilibrium Output with Flexible Prices
Suppose all firms face the same real unit cost,  (i) = . This would, for instance, be the
case if all firms have the same production functions, the same productivity levels and face
66
the same factor prices. Since all intermediate goods enter the production function of the
final good symmetrically, all prices will be equal in equilibrium; the relative price on the
right hand side of (4.11) will be one. This means that we can solve for aggregate output,
Y , in terms of the real unit cost, 
q  1
κ−1 1
Y =  1−κ , (4.12)
κ
which is decreasing in the real unit cost.
It can also be noted that it is increasing in q (assuming we can keep  (i) more or less
unchanged): a larger value of q means that the intermediate goods are closer substitutes
in the production function for the final good (4.1) and the demand curve (4.3) becomes
more elastic. With less monopoly power, output is higher. The flip side of this is that
marginal costs are lower than prices in the intermediate goods industry.
It is clear from (4.12) that money supply can only affect output through real unit
cost, , only. This means that unless monetary policy can affect the supply of labour or
capital, then it cannot affect output. This is the same result as in MIU models with perfect
competition: market imperfections do not imply a role for monetary policy. (Recall, for
instance, that money supply in MIU models is neutral in steady state, and neutral also
along an adjustment path if the utility function is separable in goods and real money
supply.)
4.1.6 Looking Ahead: Nominal Stickiness
In order to generate a really important role for monetary policy, we need some type of
nominal stickiness. One straightforward way is to add nominal wage stickiness as in
Bénassy (1995). In this case, (4.12) still holds, and effect of a money supply surprise
comes from decreasing the real unit cost (by decreasing the real wage). Alternatively, we
could add some type of stickiness in prices of intermediate goods. In this case, the profit
maximizing price is no longer (4.11), so (4.12) does no longer hold. We will study such a
case later in the course.
It was earlier argued that intermediate firms will try to raise the price in a boom,
provided the real unit cost does not decrease at the same time. However, (4.12) shows
that the only way we can get a boom is by a decrease in the real unit cost, which seems to
undermine the importance of the argument. It indeed does in an equilibrium with flexible
67
prices, but it need not do so in an equilibrium with (some) sticky prices. For instance,
when (some) prices are sticky and quantities are demand determined (for some reason,
firms post prices in advance and agree to supply whatever is demanded at the price), then
those firm that do not have sticky prices will increase them in booms.
Bibliography
Bénassy, J.-P., 1995, “Money and Wage Contracts in an Optimizing Model of the Business
Cycle,” Journal of Monetary Economics, 35, 303–315.
Blanchard, O. J., and S. Fischer, 1989, Lectures on Macroeconomics, MIT Press.
Obstfeldt, M., and K. Rogoff, 1996, Foundations of International Macroeconomics, MIT
Press.
Romer, D., 1996, Advanced Macroeconomics, McGraw-Hill.
Walsh, C. E., 1998, Monetary Theory and Policy, MIT Press, Cambridge, Massachusetts.
68
5 Money and Price Setting
Main references: Romer (1996) (Romer), Blanchard and Fischer (1989) (BF), Obstfeldt
and Rogoff (1996) (OR), and Walsh (1998)
5.1 Dynamic Models of Sticky Prices
References: BF. 8.2, Romer 6.7, Rotemberg (1987).
This section deals with the effect of price rigidities in dynamic models. Prices are set
in advance and firms are assumed to supply whatever demand happens to be (which is rea-
sonable only as long as demand shocks do not force marginal costs above the price). This
clearly assumes that firms can expand production, for instance, by hiring more labour, so
there must be a fairly elastic factor supply. If factor supply is not particularly elastic, then
marginal costs will increase rapidly so the assumption that marginal cost is always below
the price becomes implausible.
Aggregate demand shocks (or money supply) will usually have real effects when
prices adjust slowly. This is certainly the case when prices are changed with prespeci-
fied intervals (time-dependent rules), and the main issue is instead how long the effects
last. It is typically also the case when prices are changed when the old prices are too far
from the frictionless optimum (state dependent rules).
In general, we would like to find a reasonable model which can explain both why
average prices seem to adjust gradually to monetary expansions and why price changes
of individual firms appear to be “lumpy.” This is hard.
5.1.1 Quadratic Costs of Price-Adjustment
Reference: Rotemberg (1982a), Rotemberg (1982b), and Walsh 5.5.
Firm i is a monopolist on its market and sets the log price, pit , to maximize the value
of the firm: the expected discounted sum of profits. If there were no costs of adjusting
this price, then the price would be equal to some value, pit∗ , which we call the flex price
optimum.
69
 With costs of adjusting the price we formulate the maximization problem in two steps. In contrast to the model with quadratic adjustment costs, this model has lumpy indi-
First, find the flex price optimum, pit∗ . Second, minimize the loss from not being at pit∗ vidual price changes—but it gives the same evolution of the average price level (shown
and from incurring adjustment costs. For the moment, we will take the time series process below).
of pit∗ as given and focus on the second part of the maximization problem. To make any Prices are changed at exogenous random points in time only. The fraction q of the
progress, we also approximate the objective function in the second step by a quadratic firms are allowed to set a new price in a period, and the fraction 1 − q must keep their old
function price. As in the model with quadratic adjustment costs, the model is set up in two steps.
∞ h i First, find the flex price optimum, pit∗ . Second, minimize the loss from not being at pit∗ ,
X
2
min∞ Et βs ∗
pit+s − pit+s + c ( pit+s − pit+s−1 )2 or (5.1) taking into account the firm only gets a time to change its price at random occasions.
{ pit+s }s=0
s=0 ∗
n
2
2 o Let pit+s be the flex price optimum of firm i in period t + s, and pit the actual price
min pit − pit∗ + c ( pit − pit−1 )2 + βEt pit+1 − pit+1
∗
+ βcEt ( pit+1 − pit )2 + ... . set in t (and perhaps still valid in future periods if no opportunity to change the price has
{ pit+s }∞
s=0
occurred). The frequency of price changes is, unrealistically, assumed to be constant.
The first order condition with respect to pit is Suppose firm i gets to change its price in t. The minimization problem in t is to choose
the price, pit , to minimize the expected discounted loss of being away from the optimal
pit − pit∗ + c ( pit − pit−1 ) − βcEt ( pit+1 − pit ) = 0 or (5.2)
price. The loss function is once again approximated by a quadratic function
1 ∗
βEt 1pit+1 + p − pit = 1pit .


(5.3)
c it ∞
X
2
L t = Et β s p̃t+s − pit+s
∗
, (5.5)
There is no lumpiness in individual price changes. Since both deviations from the and pit∗
s=0
prices changes are much more costly when they are large (the loss function is quadratic),
where p̃t+s denotes actual price in t + s, which might have been set in the same or some
the optimal policy will be to converge to pit∗ by taking many small steps rather than a
earlier period.
few large. In a symmetric equilibrium pit = pt and pit∗ = pt∗ . It can also be noted
This loss function is potentially problematic since p̃t+s has a mixture (both discrete
that situations with a high surprise inflation will lead to a higher pit∗ − pit , so the price
and continuous parts to it) distribution, which can make it complicated to calculate the
adjustment is then faster.
∗
expected value (note that p̃t+s and pit+s are likely to be correlated in a complicated way).
The smooth individual price changes carry over to the average prices, since all firms
However, we can simplify the problem by noting that all we care about are the terms that
are similar. Let pit = pt and pit∗ = pt∗ be the common prices and write (5.3) as
involve p̃t+s = pit . First, note that the next time the firm will get to change its price is
1 ∗ in the random time t + τ1 , the second time in t + τ2 , and so forth. The probability that it
1pt = βEt 1pt+1 + pt − pt .


(5.4)
c does not get to change the price in t + 1 is 1 − q, that it does not get to change in either
Special Case: No Adjustment Cost (c = 0) t + 1 or in t + 2 is (1 − q)2 , and so forth. This means that Pr( p̃t+s = pit ) = (1 − q)s .
Second, note that Et ( p̃t+s − pit+s
∗ )2 =
 ( p̃t+s − pit+s ) d F( p̃t+s , pit+s ), where F is
∗ 2 ∗
R
If c = 0, then (5.2) shows that pit = pit∗ , so the firm will always set its actual price equal
the joint distribution function and  be understood as a Stieltjes integral over , which
R
to the unrestricted optimal price (quite obvious since the price is then unrestricted).
is the space of values of the pair { p̃t+s , pit+s
∗ }. We can split up  into two subsets: one

where p̃t+s = pit and the rest. Clearly, only the first subset matters for the first order
5.1.2 Calvo’s Model
condition with respect to pit . This subset has the probability (1 − q)s and pit+s ∗ has some
Reference: Rotemberg (1987) and Walsh 5.5. distribution (only the first moment will be important).

70 71
 We therefore rewrite the loss function (5.5) as pit∗ = pt∗
∞    
1 1−q 1 1−q
pt−1 = [1 − β (1 − q)] pt∗ + β (1 − q) Et
X
2
Lt = β s (1 − q)s Et pit − pit+s
∗
+ terms not involving pit , (5.6) pt − pt+1 − pt , or
q q q q
s=0
(5.13)
where pit is the price set in t (and still in effect in t + s with probability (1 − q)s ). (An q
1pt = βEt 1pt+1 + [1 − β (1 − q)] pt − pt .
∗


(5.14)
alternative, and more careful, derivation is given in Appendix B.) 1−q
The first order condition with respect to pit is This is of the same form as (5.4), but where the coefficients have different interpretations.
∞
X
β s (1 − q)s pit − Et pit+s
∗


= 0. (5.7) Special Case: Flexible Prices (q = 1)
s=0
P∞ If q = 1, so all firms get to change their prices in every period, then (5.10) becomes
s=0 β (1 − q)s = 1/[1 − β (1 − q)], we get
Since s

∞
X pit = pit∗ , (5.15)
pit = [1 − β (1 − q)] β s (1 − q)s Et pit+s
∗
(5.8)
s=0 so prices are set equal to the flex price optimal.
∞
X
= [1 − β (1 − q)] pit∗ + [1 − β (1 − q)] β (1 − q) β s (1 − q)s Et pit+1+s
∗
. (5.9)
Average Time between Price Changes
s=0

This can be rewritten as a forward looking difference equation in pit by noting that the Price changes follows a Poisson process, so time to a price change has an exponential
last term in (5.9) equals β (1 − q)Et pit+1 , see (5.8). (This is the price they would set in distribution.(The exponential distribution is q exp (−qτ ) for τ > 0, with Eτ = 1/q and
t + 1 if they get to change the price then.) This gives Var(τ ) = 1/q 2 .)

pit = [1 − β (1 − q)] pit∗ + β (1 − q) Et pit+1 . (5.10) 5.1.3 Other Ways to Model Price Stickiness

If all firms are similar, then pit and pit∗ are the same for all firms. The aggregate
price level is the weighted average of those who get to change the price and those who
did not. (This can be seen as an approximation to a true CPI. For instance, if the utility
function/production function for the final good is CES, then the exact CPI is also a CES
function.) The latter have, on average, a price equal to the price level in t − 1 (since the
draws are independent over time). The average price level is therefore
It is straightforward (but a bit tedious) to model multi-period price contracts. It could,
for instance, be a case where half the firms set prices for two periods in every odd time
period, and the other half in every even period (staggered price setting).
The Fischer model allows the contract to stipulate different (but predetermined) prices
for the different subperiods of the contract. The Taylor model is similar, but has the same
price for all subperiods (fixed prices), which gives more price inertia.

pt = q pit + (1 − q) pt−1 , so (5.11) 5.1.4 Price Setting in a Model with Monopolistic Competition
1 1−q
pit = pt − pt−1 (if q > 0). (5.12) What is the unrestricted optimal price, pit∗ , which plays such an important role in the
q q
previous model? A typical formulation is that it represents a monopolist’s price in a flex-
Use this to substitute for pit and pit+1 in (5.10) and let all firms have the same flex price,
price equilibrium. That price is typically an increasing function of aggregate demand and

72 73
a decreasing function of the productivity level. In logs, we write As in any Phillips curve, it appears as if inflation is a real phenomenon! This is quite
the opposite to the Cagan model, where it is assumed that both output and the real interest
pt∗ = pt + φyt + εt , (5.16) rate are constant. This suggests that this model of price setting is certainly not suitable for
understanding a permanent change in the money supply trend. It is not plausible that the
where εt is interpreted as the negative of a productivity shock (negative “supply shock”).
model parameters, for instance q and c, would remain unchanged in such a case.
Note that φ > 0. It is typically increasing in slope of the marginal cost curve (the degree
of decreasing returns to scale) and decreasing in the elasticity of substitution between
5.1.5 Closing the Model: The Demand Side
goods in consumer preferences. In most models, we need an upward sloping marginal
cost curve to get φ > 0, which could be motivated by some fixed factors of production. We need a model for yt to illustrate how this price setting works. Suppose we have
If these fixed factors are not completely fixed, but can be accumulated over time, then macro model with money in the utility function/cash in advance, optimizing households,
the problem becomes more complicated (dynamic) and (5.16) can only be interpreted as imperfect competition with (at least temporarily) decreasing returns to scale, and costs of
an approximation that might be valid for short to medium run horizons (a business cycle, changing nominal prices. We also add the assumption that firms with sticky prices agree
say). to sell any quantity demanded at the prevailing price.
Using (5.16) in (5.4) gives In this setting, (5.19) describes how firms set prices. The rest of the model would be
1 something like the following. Money demand is
1pt = βEt 1pt+1 + (φyt + εt ) . (5.17)
c
m t − pt = ψ yt − ωi t . (5.21)
Similarly, using (5.16), in (5.13) gives
−γ −γ
q The Euler equation for consumption is Ct = (1 + rt+1 )Et Ct+1 , which is approximately
1pt = βEt 1pt+1 + [1 − β (1 − q)] (φyt + εt ) . (5.18) equal to the following (in logs)
1−q
We write both these equations as −γ ct = −γ Et ct+1 + rt+1 or rt+1 = γ (Et ct+1 − ct ) , (5.22)

1pt = βEt 1pt+1 + δ (φyt + εt ) , (5.19) where rt+1 is the real interest rate. If assume that consumption is approximately propor-
tional to output, then (5.22) can be written
which can be thought of as an expectations-augmented Phillips curve. It is in an sense
similar to the Keynesian AS curve, which has positive relation between output and the rt+1 = γ (Et yt+1 − yt ) + constant. (5.23)
price level.
Recursion forward gives The Fisher equation is
∞
i t = Et ( pt+1 − pt ) + rt+1 . (5.24)
X
1pt = δ β s Et (φyt+s + εt+s ) , (5.20) Finally, we have to add an assumption about what the central bank uses as its instrument:
s=0
m t or i t . This is the whole model. We could clearly add more features, for instance, a
provided lims→∞ β s+1 Et 1pt+s = 0. Note that Et yt+s has a large effect on inflation is φ is labour supply decision (must be elastic to let the firms expand output), but we disregard
high (strong decreasing returns to scale and/or strong market power), and Et (φyt+s + εt+s ) that in order to keep the model as simple as possible.
has a large effect if δ is high (small c in (5.17) or large q in (5.19)). Consider the case when the central bank sets m t . When money is interest rate elastic,

74 75
ω 6 = 0, then (5.19) and (5.21) are no longer sufficient to close the model, since the sticky price model. Substitute for yt in (5.19) by using (5.25)
nominal interest rate remains to be determined. From the Fisher equation (5.24) we see
that determining the nominal interest rate requires both inflation (already captured by 1pt = βEt 1pt+1 + δφ (m t − pt ) + δεt
(5.19)) and the real interest rate. We therefore need a model of the real interest rate, for − pt−1 + pt (1 + β + δφ) − βEt pt+1 = δ (φm t + εt ) . (5.26)
instance, (5.23), to close the model. In contrast, when ω = 0, then we do not need a
This is a second-order expectational difference equation, which can be solved with a
model of the real interest rate in order to solve for the equilibrium price and output. Of
variety of methods. The perhaps most straightforward one is to specify a time-series
course, we can always plug in the equilibrium process for yt in (5.23) to calculate the
process for the exogenous driving process, and transform the system to a vector first-order
implied real interest rate, but we do not have to.
system and then use a decomposition of the resulting matrix to decouple the variables in
Now, consider the case when the central bank sets i t . In this case, we do not need the
those that are predetermined in t (typically the exogenous variables and values determined
money demand equation (5.21) for determining the price and output. Instead, we combine
in previous periods like the capital stock and lagged variables) and those that can jump
(5.19) with (5.23) and (5.24) to give us a model in terms of the price, output, real interest
in t in response to changes in expectations about future values (typically asset prices and
rate, and the nominal interest rate (set by central bank). Of course, we can always plug in
anything else that depend on expected future values).
the equilibrium values in (5.21) to calculate money demand, but we do not have to.
A trivial step is to note that (5.26) can be rewritten

5.1.6 Example: Calvo Model in a Very Simple Macro Model 1 1 + β + δφ δ

Et pt+1 = − pt−1 + pt − (φm t + εt ) . (5.27)
β β β
For simplicity, assume that the quantity equation holds. In logs we have
Suppose εt = 0 and that m t is an AR(1)
m t = pt + yt . (5.25)
m t = ρm t−1 + εmt . (5.28)
This can be taken to represent aggregate demand. Aggregate supply is represented by
We can then write the model on state space form as
the price setting rule, and it is assumed that firms supply whatever the market demands
at the going price: output is demand determined. In traditional monetarist models, the ρ εmt+1
      
m t+1 0 0 mt
quantity equation is aggregate demand, without much discussion of where it comes from.  pt

= 0
 
0 1   pt−1  +  0
  
.

(5.29)
In a Keynesian model, the quantity equation would be an approximation to the Keynesian Et pt+1 − βδ φ − β1 1+β+δφ
β p t 0
AD curve (the combination of the IS and LM curves which traces out the relation between
output and prices). Both these interpretations assume a negative relation between the price Some impulse response functions (dynamic simulations obtained from setting εmt = 1
level and output. In some modern dynamic general equilibrium models, the quantity in t = 0 but zero in all other periods) are shown in Figure 5.1. In Figure 5.1.a, price ad-
equation can be shown to be the money demand equation (see, for instance, Bénassy justment is fairly slow (many prices are fixed in spite of an increase in nominal demand),
(1995)). so a monetary shock leads to a relatively large effect on output: money is far from neutral.
We now use this very simple model of “demand” to illustrate some properties of the In Figure 5.1.b, price adjustment is much faster (the rate at which an occasion to change
the price arrives is much higher), so the monetary shock has almost no effect on output:
money is almost neutral. In Figure 5.1.c also has fat price adjustment, but now because
φ is high (quickly decreasing returns to scale or strong monopoly power), which makes it
too costly for firms to keep their old prices.

76 77
 a. Baseline model b. Frequent price adjustments, q=0.99 on which type of policy experiments which are meaningful to analyze with the help of
1 1 this model: we should probably only use this model for policy changes which keeps the
average inflation rate unchanged. In many applications, the Phillips equation is assumed
0.5 0.5 to refer to detrended output (as a measure of the business cycle). The main reason is
money that the Phillips effect is typically only relevant for as long as the production function
price
0 0 has decreasing returns to scale, see the discussion of (5.16). Since detrended output per
output

−2 0 2 4 6 8 −2 0 2 4 6 8
definition has a zero mean the kind of experiments that changes Eyt must be ruled out.
period period
5.1.8 Empirical Illustration

c. Prices sensitive to demand, φ=2 Calvo model, response to money supply shock • Relation between output and unemployment: Okun’s law, 1 ln Yt = 31u t .
1 Parameter values (base line):
ρ=0.95, φ=3/7, q=0.875, β=0.96 • Phillips curve unstable, in particular if not accounting for Et πt+1 . (Burda and
0.5 Wyplosz (1997) Figs. 12.4 and 12.6)

• OR Box 10.2 (substantial evidence of imperfect competition from micro data of 50

0
US industries)
−2 0 2 4 6 8
period • OR Box 10.1 (12-18 months between price changes on selected items in US mail
catalogues)

Figure 5.1: Impulse responses in the Calvo model
5.1.7 The Calvo Model and the “Natural Rate Hypothesis”
Reference: Walsh 5.5.
The “natural rate hypothesis” states that the mean of output cannot be affected by any
monetary policy. Suppose the central bank can change the inflation rate by changing its
policy instrument. Take the unconditional expectation of the Calvo model (5.19) and use
iterated expectations and Eεt = 0 to get
E1pt − βE1pt+1
Eyt = . (5.30)
δφ
If β = 1 (β < 1), and inflation is a stationary series so E1pt = E1pt+1 , then this
means that inflation cannot (can) affect average output. Irrespective of whether β = 1 or
not, a drifting inflation rate (E1pt 6=E1pt+1 ) can certainly affect average output.
This should probably be regarded as an artifact of the Calvo model. It puts restrictions
• Rotemberg (1982b) finds that for Germany the average time between price changes
was 4 quarters. It must therefore be the case that 1/q = 4, so q = 1/4. He reports
even lower numbers for the US.
• Roberts (1995) estimates
1pt −Et 1pt+1 = co +γ yt +c1 1 log real oil pricet +c2 1 log real oil pricet−1 +εt ,



where 1pt is measured by the percentage increase December to December in CPI,
yt GDP detrended with a deterministic trend (time and time squared), and Et 1pt+1
is approximated by inflation expectation surveys. The sample is annual and covers
1949-1990. The results are γ ≈ 0.3. If we use this together with q = 1/4 (from
Rotemberg (1982b)) and β = 1 in (5.18), we get φ ≈ 3.6, so a one percent increase
in aggregate demand drives up the desired relative price of a monopolist with 3.6
percent.

78 79
5.2 Aggregation of One-Sided Ss Rule: A Counter-Example to 1M → [s, S] with pdf
1
1Y f p∗ − p = .


∗ (5.35)
S−s
What is the effect on real balances of an infinitesimal increase in money stock dm.
Reference: BF. 408-414, Romer 273-276.
For all firms which have p ∗ − p ∈ [s, S), that is, below the point which triggers a price
Basic point: individual price stickiness does not necessarily imply aggregate price
change, all firms are simply shifted up in parallel. For all firms which are moved to the
stickiness.
trigger point ( p ∗ − p = S), we see an immediate adjustment of the price to, so p ∗ − p = s.
If there where no adjustment costs the optimal nominal price of a firm i is
These two movements completely offsets each other, so the average p ∗ − p is unchanged.
pit∗ = m t . (5.31) If supply depends on real balances, then output is unaffected by the change in money
supply.
Assume that m t is non-decreasing, so Critical assumptions and discussion. The initial distribution is uniform and shocks
are small. The general contribution of the model is to highlight the importance of the dis-
m t ≥ m t−1t , (5.32)
tribution of price/frictionless price. One could envision a situation where a large fraction
which makes the frictionless optimum pit∗ drift upwards. Suppose the actual price set by of firms are close to adjusting there price upwards. I small (but not infinitesimal) change
the firm is pit , and that there is a menu cost for changing the price. It can be shown that a in money supply can then trigger a disproportionate jump in the average price level, so
one-sided Ss rule is optimal that a monetary expansion leads to a recession.
(
pit−1t if pit−1t > pit∗ − S, S > 0
pit = , (5.33)
pit∗ − s else, s < 0. A Summary of Solution Method for Linear RE Models
where S and s depend on the drift and the menu cost.
A.1 Summary
This rule implies that the nominal price is unchanged as long as the frictionless op-
timum p ∗ is not much larger that the actual price. At a price change, the actual price is The model is " # " # " #
set somewhat higher than the frictionless price pit = pit∗ − s, s < 0, in expectation of x1t+1 x1t εt+1
=A + , (A.1)
increases in pi∗ (m t drifts upwards all the time). Et x2t+1 x2t 0
Consider an example. We start with p0 = p0∗ , and then pt∗ increases until it reaches where x1t is an n 1 × 1 vector of predetermined variables, x2t is an n 2 vector of “forward
p0 + S in period τ . At that time the actual price is changed to looking” variables, and εt is a white noise process. All dynamics of the exogenous pro-
cesses have been placed in x1t . A necessary condition for a saddle path equilibrium is that
pτ = pτ∗ − s A has as many unstable roots (inside unit circle) as there are elements in x1t .
= p0 + S − s /*price is changed when pτ∗ = p0 + S*/ Decompose A as
> p0 + S /*since s < 0*/ (5.34) A = Z T Z −1 , (A.2)

where T is (at least) upper block diagonal. Note that we require Z to be invertible. In
The deviation p ∗ − p moves within the band [s, S].
some cases we could let T be a diagonal matrix with eigenvalues along the principal
In general, this type of setup implies a uniform distribution of p ∗ − p over the band
diagonal and with the corresponding eigenvectors in the columns of Z (if the eigenvectors

80 81
are linearly independent). We assume that a and b are such that |λ1 | < 1 but |λ2 | > 1.
This decomposition should be reordered so that the blocks corresponding to the stable
Example 28 a = 1.1 and b = 0.3 gives λ1 ≈ −0.23 and λ2 ≈ 1.323.
eigenvalues (in or on the unit circle) comes first. Partition conformably with the stable
and unstable roots In this case, (A.4) gives
" # " # xt = λ1 xt−1 , (A.11)
Tθθ Tθδ Z kθ Z kδ
T = and Z = . (A.3) since Z kθ = −λ2 /b and Tθθ = λ1 .
0 Tδδ Z λθ Z λδ
It is straightforward to show that (A.11) satisfies (A.6). From (A.11), xt = λ1 xt−1 ,
The solution can then be shown to be so xt+1 = λ1 xt = λ21 xt−1 , so (A.6) becomes
−1
x1t+1 = Z kθ Tθθ Z kθ x1t + εt+1 (A.4) λ21 − aλ1 − b, (A.12)
x2t = −1
Z λθ Z kθ x1t . (A.5)
which should be zero. Substituting for a and b from (A.10) immediately shows that this
is the case.
A.2 Special Case: Scalar Second Order Equation
We now generalize the scalar difference equation to
Reference: Romer 6.8, BF Appendix to chap 5, Hamilton (1994) 2.3.
Et xt+1 − axt − bxt−1 = Et z t , (A.13)
Consider the homogenous scalar second order difference equation
where z t is some exogenous process.
xt+1 − axt − bxt−1 = 0. (A.6)
It can then be shown that the solution is
∞ 
We can write the difference equation as a system of first order equations as in (A.1) 1 X 1 s

xt = λ1 xt−1 − Et z t+s . (A.14)
(with εt = 0 for all t) λ2 λ2
s=0
" # " #" #
xt 0 1 xt−1
= . (A.7)
xt+1 b a xt We now demonstrate that this solution indeed satisfies (A.13). First, lead (A.14) ones
The matrix can be decomposed in terms of eigenvalues and eigenvectors. It can be shown period, take expectations as of time t and then use this to substitute for Et xt+1 in (A.13).
that the decomposition is ∞ 
" #
1 X 1 s

Et z t = λ1 xt − Et z t+s+1 − axt − bxt−1 . (A.15)
" # " #" #" #−1 λ2 λ2
0 1 −λ2 /b −λ1 /b λ1 0 −λ2 /b −λ1 /b s=0
= , (A.8)
b a 1 1 0 λ2 1 1 Second, note that
∞  ∞ 
where 1 X 1 s 1 s
 
√ X
Et z t+s − Et z t ,
" # " #
λ1 1 1 2 + 4b Et z t+s+1 = (A.16)
= 2a − 2 √a , (A.9) λ2 λ2 λ2
s=0 s=0
λ2 1
2a + 1
2 a
2 + 4b
and where the eigenvalues satisfy which we use in (A.15)
∞ 
" #
1 s

a = λ1 + λ2 and b = −λ1 λ2 .
X
(A.10) Et z t = λ1 xt − Et z t+s + Et z t − axt − bxt−1 . (A.17)
λ2
s=0

82 83
Third, subtract Et z t from both sides and use (A.14) to substitute for xt in (A.17) Factor the polynomial within parenthesis as
∞  s ∞  s
0 = (λ1 − a) λ1 xt−1 − (λ1 − a)
1 X 1
Et z t+s −
X 1
Et z t+s − bxt−1 . 1 − aL − bL2 = (1 − λ1 L) (1 − λ2 L) (A.21)
λ2 λ2 λ2
s=0 s=0 = 1 − (λ1 + λ2 ) L + λ1 λ2 L , so2
(A.22)
(A.18)
a = λ1 + λ2 and b = −λ1 λ2 , with (A.23)
From (A.10) we know that (λ1 − a) /λ2 = −1, so the terms involving Et z t+s cancel.
a 1p 2
Since (λ1 − a) λ1 = b also the terms involving xt−1 cancel (bit we already knew that λ1,2 = ± a + 4b. (A.24)
2 2
from the homogenous equation).
Assume |λ1 | < 1 and |λ2 | ≥ 1 (must be shown for each model). Use (A.22) in (A.19)
Example 29 (z t is AR(1).) Suppose z t+1 = ρz t + εt+1 . The state space form is then
L−1 (1 − λ1 L) (1 − λ2 L) Et xt = Et z t
ρ 0 εt+1
      
z t+1 0 zt
 
(1 − λ1 L) L−1 − λ2 Et xt = /*multiply in L−1 */
 xt = 0 0 1   xt−1  +  0 ,
      
 
1 1
Et xt+1 1 b a xt 0 (1 − λ1 L) 1 − L−1 Et xt = − Et z t /* divide both sides with − λ2 */ (A.25)
λ2 λ2
and we could employ the spectral decomposition to solve this problem. Alternatively, note Apply the operator
that the AR(1) for z t gives Et z t+s = ρ s z t , so (A.14) can be written
1 −1 2
 −1  
1 −1 1 −1
1 1 1− L =1+ L + L + ... (A.26)
xt = λ1 xt−1 − zt . λ2 λ2 λ2
λ2 1 − ρ/λ2
on both sides of (A.25)
A.3 An Alternative for the Scalar Second Order Equation: The Fac- !
1 −1 2
 
1 1 −1
torization Method (1 − λ1 L) Et xt = − 1+ L + L + ... Et z t
λ2 λ2 λ2
∞  s
Reference: Romer 6.8, BF Appendix to chap 5. 1 X 1
xt = λ1 xt−1 − Et z t+s (A.27)
The scalar difference equation is λ2 λ2
s=0

Et xt+1 − axt − bxt−1 = Et z t (A.19) B Calvo’s Model: An Alternative Derivation

 
L −1
1 − aL − bL2 Et xt = Et z t (A.20)
The actual price p̃t+s will then be one of pit , ..., pit+s , depending on the realization of
where z t is some exogenous process. The lag operator (L) affects the dating of the vari- some random variable. In particular, let us write
able, but not of the expectations operator: L−1 Et xt =Et xt+1 , Et xt = xt , LEt xt =Et xt−1 = s
X
xt−1 . p̃t+s = Iτ (vt+s ) pit+τ , (B.1)
τ =0

where vt+s is a random variable (note that there is a different random variable for each
t + s) and Iτ an indicator function. For a given realization of vt+s , one of the functions

84 85
I0 , ..., Is is unity and all other are zero. For instance, if I2 is unity, then the actual price in Blanchard, O. J., and S. Fischer, 1989, Lectures on Macroeconomics, MIT Press.
t + s (assuming s ≥ 2) equals the price set in t + 2. We can then write (5.5) as
Burda, M., and C. Wyplosz, 1997, Macroeconomics - A European Text, Oxford University
∞ s
!2
X X Press, 2nd edn.
L t = Et βs Iτ (vt+s ) pit+τ − pit+s
∗
(B.2)
s=0 τ =0 Hamilton, J. D., 1994, Time Series Analysis, Princeton University Press, Princeton.

2 2
pit∗ + Et βI0 (vt+1 ) pit + I1 (vt+1 ) pit+1 − pit+1
∗

= pit − +
2 Obstfeldt, M., and K. Rogoff, 1996, Foundations of International Macroeconomics, MIT
Et β I0 (vt+2 ) pit + I1 (vt+2 ) pit+1 + I2 (vt+2 ) pit+τ − pit+2 + ...
2 ∗

Press.
The first order condition with respect to pit is then Roberts, J. M., 1995, “New Keynasian Economics and the Phillips Curve,” Journal of
∞ s Money, Credit, and Banking, 27, 975–984.
!
X X
0 = Et β s
Iτ (vt+s ) pit+τ − pit+s I0 (vt+s )
∗
(B.3)
s=0 τ =0 Romer, D., 1996, Advanced Macroeconomics, McGraw-Hill.
= pit − pit∗ + Et β I0 (vt+1 ) pit + I1 (vt+1 ) pit+1 − pit+1
∗
I0 (vt+1 ) +

 
Rotemberg, J. J., 1982a, “Monopolistic Price Adjustment and Aggregate Output,” Review
Et β I0 (vt+2 ) pit + I1 (vt+2 ) pit+1 + I2 (vt+2 ) pit+τ − pit+2 I0 (vt+2 ) + ...
2 ∗
 
of Economic Studies, 49, 517–531.
Since Iτ (vt+s ) I0 (vt+s ) = 0 for τ 6 = 0 Rotemberg, J. J., 1982b, “Sticky Prices in the United States,” Journal of Political Econ-
∞
X omy, 60, 1187–1211.
β s I0 (vt+s ) pit − pit+s
∗
I0 (vt+s ) = 0.


Et (B.4)
s=0 Rotemberg, J. J., 1987, “New Keynesian Microfoundations,” in Stanley Fischer (ed.),
Now use the facts that Et I0 (vt+s ) =Et I0 (vt+s ) I0 (vt+s ) = Pr (I0 (vt+s ) = 1), pit is NBER Macroeconomics Annual . pp. 69–104, NBER.
∗
known in t, pit+s and I0 (vt+s ) are independent to get Walsh, C. E., 1998, Monetary Theory and Policy, MIT Press, Cambridge, Massachusetts.
∞
X
β s Pr (I0 (vt+s ) = 1) pit − Et pit+s
∗


Et = 0. (B.5)
s=0

Finally, recall that Pr (I0 (vt+s ) = 1) = (1 − q)s , which gives

∞
X
β s (1 − q)s pit − Et pit+s
∗


Et = 0. (B.6)
s=0

Bibliography
Bénassy, J.-P., 1995, “Money and Wage Contracts in an Optimizing Model of the Business
Cycle,” Journal of Monetary Economics, 35, 303–315.

86 87
 Poole (1970), Mishkin (1997) 23) Suppose the goal of monetary policy is to stabilize
output. The central bank must set its instrument (either m t or i t ) before the shocks have
been observed. Which instrument should it choose? If i t is kept fixed, then
6 Monetary Policy dyt dyt
= 0 and = 1, (i t fixed)
Main references: Romer (1996) (Romer), Blanchard and Fischer (1989) (BF), Obstfeldt dεmt dε yt
and Rogoff (1996) (OR), and Walsh (1998). since the money demand shocks are not allowed to spill over to output, and the interest
rate is not allowed to cushion real shocks. If m t is kept fixed, then
6.1 The IS-LM Model dyt 1 dyt 1
=− < 0 and = < 1, (m t fixed)
dεmt ω/γ + ψ dε yt 1 + γ ψ/ω
Reference: Romer 5, BF 10.4, and King (1993).
The IS curve (in logs) is since money demand shocks now increase the nominal interest rate and thereby decreases
output, but the real shocks are cushioned by the increase in interest rates. Poole’s conclu-
−yt + ε yt
yt = −γ i t + ε yt ⇒ i t = , (6.1) sion was that interest rate targeting is preferred if most shocks are money demand shocks,
γ
while money stock targeting is better if most shocks are real. This is illustrated in Figure
where ε yt is a real (demand) shock. The LM curve (in logs) is 6.1.
ψ yt + εmt − m t + pt
m t − pt = ψ yt − ωi t + εmt ⇒ i t = , (6.2) Example 31 (The Mundell-Flemming Model and choice of exchange rate regime, Refer-
ω
ence: OR 9.4, Romer 5.3, and BF 10.4) Add a real exchange rate term to the IS curve
where εmt is a money demand shock. Consider fixed prices, which amounts to assuming a
(6.1)
perfect elastic aggregate supply schedule: income is demand driven, which is the opposite
yt = −γ i t + φ st + pt∗ − pt + ε yt ⇒


to RBC models where income is essentially supply driven. Increasing m t lowers the
interest rate, which increases output. An outward shift in the IS curve because of an −yt + ε yt + φ st + pt∗ − pt


it = ,
increase in ε yt , increases both output and the nominal interest rate. γ
The most important problem with this model is that there are no supply-side effects,
and let asset market equilibrium be given by the UIP condition
that is, prices are fixed. As a logical consequence, the IS curve is written in terms of
the nominal interest rate, which differs from the real interest rate by a constant only. i t = i t∗ + E1st+1 .
At a minimum, this model need to be amended with a model for prices (and thus price
expectations), and also a term γ Et 1pt+1 in the IS curve to let demand depend on the ex Assumptions: fixed prices, foreign and domestic goods are imperfect substitutes, foreign
ante real interest rate. and domestic bonds are perfect substitutes. Assume also that E1st+1 = 0 so i t = i t∗ (this
The IS-LM framework has, in spite of these problems, been used extensively to dis- does, of course, allow st to change—and makes a lot of sense if all shocks are permanent).
cuss many important monetary policy issues. The following examples summarize two of If m t is fixed, so the exchange rate is floating (set m t = 0, for simplicity), then the LM
equation gives i t = (ψ yt + εmt ) /ω or yt = ωi t∗ − εmt /ψ (since i t = i t∗ ) so


them.
dyt 1 dyt
Example 30 (Monetary Policy: Interest Rate Targeting or Money Targeting? BF. 11.2, = − < 0 and = 0 (m t fixed, st floating).
dεmt ψ dε yt

88 89
 a. Interest rate targeting to accommodate the extra money demand to keep the exchange rate fixed (that is, the
i
Real shock Money demand shock output shock is not allowed to increase the nominal interest rate). A fixed exchange rate
IS (or a currency union) means that the country abandons the possibility to use monetary
policy to buffer country specific real shocks (a common real shock among the participating
countries can be buffered), but all money demand shocks are buffered. The extent of
country-specific shocks is a main determinant behind optimum currency areas (the other
LM
is the degree of factor mobility). The conclusion from this analysis is that a floating
exchange rate is better at stabilizing output if real shocks dominate, while a fixed exchange
y y
rate is better if money demand shocks dominate.

b. Money stock targeting

Real shock Money demand shock

6.2 The Barro-Gordon Model
i

6.2.1 The Basic Model

References: Walsh 8, OR 9.5, BF 11.2 and 11.4, and Romer 9.4 and 9.5.
Use the LM curve (6.2) in the IS curve (6.1) to derive the aggregate demand curve
γ ω
ytd = (m t − pt − εmt ) + ε yt . (6.3)
ω + γψ ω + γψ
y y
For simplicity, merge −εmt + ω/ (ω + γ ψ) ε yt into a composite demand shock, εtd ,
γ
ytd = (m t − pt ) + εtd . (6.4)
Figure 6.1: Poole’s analysis of different monetary policy instruments in an IS-LM model. ω + γψ
The real shock is a positive aggregate demand shock, and the money demand shock is a
positive shock to money demand. This is a very common formulation of aggregate demand; it shows up in Lucas’ model
of the Phillips curve, and also in several monetary models with monopolistic competition
A money demand shock has a negative effect on output (similar to a closed economy (see, for instance, BF 8.1). Note, however, that if the IS curve depended on the ex ante
model), while a real shock has not (different from a closed economy model). yt cannot real interest rate instead of the nominal interest rate, then a term Et 1pt+1 ωγ /(ω + γ ψ)
increase unless m t , i t∗ or εmt does. If they do not, then any real shock must simply spill is added to (6.4).
over into an exchange rate appreciation. If the exchange rate is fixed, say st = 0, then the We now also introduce an aggregate supply side inspired by Lucas’ version of the
IS equation gives i t = −yt + ε yt /γ or yt = −γ i t∗ + ε yt (since i t = i t∗ ) so Phillips curve or by a model with predetermined prices (or long nominal contracts)


 
dyt dyt yts = b pt − pt|t−1
e
+ εts , (6.5)
= 0 and = 1 (st fixed).
dεmt dε yt  
= b πt − πt|t−1
e
+ εts /* ± pt−1 */ (6.6)
All shocks to the LM curve must be accommodated by corresponding changes in m t to
e
keep st fixed. Any real shocks feed right through, since the money stock is expanded where pt|t−1 is the log price level in t which private agents expect based on the informa-

90 91
tion in t −1, and πt|t−1
e
is the corresponding expected inflation rate, πt|t−1
e e
= pt|t−1 − pt−1 . that the policy rule is on the form
Let expectations be rational, so πt|t−1 in (6.6) is the mathematical expectation
e
πt = α + βεts + δεtd , (6.9)
πt|t−1
e
= Et−1 πt . (6.7)
where we have to find the values of α, β, and δ. The public’s expectations must be
To simplify the algebra we note that the central bank can always generate any inflation it
wants by manipulating the money supply, m t . We therefore treat inflation πt as the policy πt|t−1
e
= Et−1 πt
instrument (the required m t can be backed out from the equilibrium). = α, (6.10)
The loss function of the central bank is
provided the shocks are unpredictable. Note that α is not determined yet. The idea is that
Lt = πt2 + λ (yt − ȳ) ,2
(6.8) whatever value of α that the central bank would happen to choose, the public knows it and
will adjust their expectations accordingly. This means that the central bank can influence
so the central bank want to stabilize inflation around its natural level (normalized to zero), the public’s expectations and that it makes use of this in the optimization problem.
but output around ȳ, which may be different from the natural level (once again normalized Using the supply function (6.6) and (6.9)-(6.10) in the loss function (6.8), and taking
to zero). The target level for output, ȳ, is typically positive—perhaps the natural level of expectations as of t − 1 gives the optimization problem
output (zero) is not compatible with full employment (due to labour market imperfections)
2 2
Et−1 L t = Et−1 α + βεts + δεtd + λEt−1 b α + βεts + δεtd − α + εts − ȳ . (6.11)


or because the natural level of output is affected by product market imperfections. Using
monetary policy to solve such imperfections is probably not the best idea; in this model,
The first order condition with respect to α gives
it will not even work.
The central bank sets the monetary policy instrument after observing the shock, εts . α = 0. (6.12)
(This is different from the two examples given at the beginning of this note, where policy
had to be set before the shocks were realized.) In practice, monetary policy can react The first order condition with respect to δ is
quickly, although perhaps not completely without a lag. However, the main point in this
2δσdd + 2λb2 δσdd = 0 or δ = 0, (6.13)
analysis is that the monetary policy can react more quickly than the private sector (price
and wage setters). This is probably a realistic assumption. This opens a channel for provided the shocks are unpredictable and also uncorrelated, Et−1 εtd εts = 0. Finally, the
monetary policy to have effect. first order condition with respect to β is then

6.2.2 Monetary Policy with Commitment 2βσss + 2λb (bβ + 1) σss = 0 or

λb
In the commitment case, the central bank chooses a policy rule in t − 1 and precommits β=− . (6.14)
1 + λb2
to it. It will therefore choose a rule which minimizes Et−1 L t . Since the model is linear-
The policy rule (6.9) is therefore
quadratic, we can assume that the policy rule is linear. Since only innovations can affect
output we can safely restrict attention to policy rules in terms of a constant (there is no πt = βεts , (6.15)
dynamics in the model) and the shocks. We therefore assume (correctly, it can be shown)

92 93
with β given by (6.14). Output is then All parameters are positive. A positive shock to εtd increases both output and price pro-
portionally, so a decrease in m t can stabilize the effects completely. This can also be seen
yt = (bβ + 1) εts . (6.16) directly from (6.4). In contrast, a positive shock to εts increases output but decreases the
price. Since the effect of m t on output and price has the same sign, the central bank can-
If the central bank targets inflation only, λ = 0, then β = 0, which by (6.15) and (6.16)
not use monetary supply to stabilize both when the economy is hit by a supply shock. If
means that inflation is completely stable and that output shocks are not cushioned. Con-
it opts for increasing m t , then this may stabilize the price but destabilizes output further,
versely, if the central bank targets output only, λ → ∞, then β = −1/b (apply l’Hôpital’s
and vice versa.
rule) so output is now completely stable, but inflation varies.
More generally, note that
6.2.3 Monetary Policy without Commitment (Discretionary)
2
∂ ∂ 2 ∂ λb 2λb2

1
Var(πt ) = β = − =
3 > 0 and (6.17) One problem with the commitment equilibrium is that the policy rule announced in t − 1
Var(εt ) ∂λ
s
∂λ ∂λ 1 + λb 2
1 + λb2
2 may no longer be the optimal rule in t. At that time, inflation expectations can be treated
∂ ∂ ∂ λb2 b2

1 as given (for instance, inflation expectations might enter the model because they repre-
Var(yt ) = (bβ + 1)2
= − + 1 = −2
3 < 0.
Var(εts ) ∂λ ∂λ ∂λ 1 + λb2 1 + λb2 sent nominal contracts written in t − 1). The central bank could have an incentive to
(6.18) exploit this: the policy rule is then not “time consistent.” If the central bank cannot com-
As expected, the variance of π is therefore increasing in λ. Conversely, the variance of mit to a policy rule, then the time inconsistent rule is not credible, and the commitment
output decreasing in λ. equilibrium falls apart.
We now assume that the central bank cannot commit to a rule. Instead, we look
Example 32 When b = 1, then πt = −λ/(1+λ)εts and yt = 1/(1+λ)εts so Var(πt )/Var(yt ) = for a policy that is optimal in t (after the shocks have been observed), when πt|t−1 is
λ2 , which is clearly increasing in λ. taken as given. If this happens to be the same decision rule as above, then there is no
time inconsistency problem—otherwise there is. With discretionary monetary policy, the
The policy rule implies that average inflation is zero, α = 0. There is no point in choice of inflation minimizes
creating a non-zero average inflation, since anticipated inflation does not affect output.  2
The policy rule also implies that demand shocks should always be completely offset: πt2 + λ bπt − bπt|t−1
e
+ εts − ȳ . (6.19)
they do not enter either inflation (6.15) or output (6.16). The reason is that demand shocks
There is no expectations operator, since the central bank makes its decision after the
push prices and output in the same direction, so there is no trade-off between price and
shocks are realized, and it does not precommit (before the shock) to follow any particular
output stability. Only supply shocks, which push inflation and output in different direc-
decision rule.
tions, gives a trade-off.
e The first order condition with respect to πt is
To see this, let us simplify by setting price expectations in (6.5), pt|t−1 , to zero and
also revert to considering m t as the policy instrument (there is a one-to-one relation to the πt = −πt λb2 + λb2 πt|t−1
e
− λbεts + λb ȳ, (6.20)
inflation rate). We can then solve the system (6.4) and (6.5) for output and price as
" # " # " #" # with (two times the) marginal cost of inflation on the left hand side and (two times the)
yt γb b (ω + γ ψ) γ εtd
[b (ω + γ ψ) + γ ] = mt + marginal benefits on the right hand side. The public knows that (6.20) will determine
pt γ ω + γψ − (ω + γ ψ) εts
how the central bank acts. They therefore form their expectations in t − 1 by rationally

94 95
using all available information. Taking mathematical expectations of (6.20) based on the The high inflation between mid 1960s and early 1980s could possibly be due to the
information available in t −1 and rearranging gives that expectations formed in t −1 must lack of commitment technology combined with more ambitious employment goals. An
be alternative explanation is that the policy makers believed in a long run trade-off between
πt|t−1
e
= λb ȳ. (6.21) unemployment and inflation.

Combine this with (6.20) to get

6.2.4 Empirical Illustration
λb
πt = λb ȳ − εs Walsh Fig 8.5 (relation between central bank independence and average inflation).
1 + λb2 t
= λb ȳ + βεts (6.22)
6.3 Recent Models for Studying Monetary Policy
This rule has the same response to the output shock as the commitment rule, but a higher
average inflation (if both λ and ȳ are positive). The first of these results means that This section gives an introduction to more recent models of monetary policy. Such models
the variances are the same as in the commitment equilibrium. The reason is that there typically combine a forward looking Phillips curve, for instance, from a Calvo model,
is no persistence in this model. In a model with more dynamics this will no longer be with an aggregate demand equation derived from an optimizing consumer’s intertemporal
true—in that case we can intuitively think of the natural output level, here normalized to consumption/savings decision, and some kind of policy rule or objective function for the
zero, as time varying. This makes the difference between commitment and discretionary central bank.
equilibrium more complicated.
The second of the results, the higher average inflation, is due to the incentive to deviate 6.3.1 A Simple Model
from the commitment rule—and that the public incorporates that when forming inflation
Price are set as in the Calvo model. In this model, a fraction q of the firms are allowed
expectations. To understand the incentives to inflate consider (6.20) when πt|t−1 e
= εts =
to set a new price in a period, and the fraction 1 − q must keep their old price. When
0. If the central bank then sets πt = 0 (so there is no policy surprise), then the marginal
allowed to change the price, the firms chooses a price to minimize a discounted sum of
cost of inflation (left hand side) is zero, but the marginal benefit (right hand side) is λb ȳ.
the squared deviations of the actual price and the flex price. (See Rotemberg (1987) and
If both λ and ȳ are positive, then there is an incentive to inflate. Private agents will realize
MacPri.TeX for details.) We also assume that the flex price is determined as in model
this and form their expectations accordingly. The equilibrium is where Et πt = πt|t−1 e
and
of monopolistic competition, pit∗ = pt + φyt + επ t , where φ measures how much price
marginal cost and benefits are equal.
setters wants to increase the relative price when demand increases (φ is high when the
It is often argued that making the central bank more independent of the government
substitution elasticities between goods is low and when the marginal cost curve is steep).
is quite similar to a lower λ, that is, to a lower relative weight on output. From (6.22) we
The supply side of the economy can then be summarized by the “Phillips curve”
see that this should lower the average inflation rate. At the same time, it should lower the
variability of inflation, but increase the variability of output, see (6.17)-(6.18). πt = βEt πt+1 + δ (φyt + επt ) , (6.23)
It is still unclear if the inflation bias is important. There are many other cases where
the logic of the discretionary equilibrium seems unappealing, for instance, in capital in- where δ is increasing in the fraction q.
come taxation (why is not all capital confiscated every year?). It might be the case that The “aggregate demand” curve is derived in Section A from an Euler condition for
society has managed to set up institutions and informal rules which create some kind of optimal consumption choice with taste shocks, combined with the assumption that con-
commitment technology.

96 97
sumption equals output. It is We can write (6.23)-(6.26) as
     
1 1 0 0 0 επt+1 τπ 0 0 0 επt
Et yt+1 = yt + (i t − Et πt+1 ) + ε yt , (6.24)
γ  0 1 0 0   ε yt+1
   
  0 τy 0 0

 ε yt


  =  +
where ε yt is a negative shock to current (time t) demand.  0 0 β 0  E π   −δ 0 1 −δφ   πt 
   t t+1    
The central bank sets short interest rate, i t . This can have effect on output since prices 0 0 γ1 1 Et yt+1 0 1 0 1 yt
   
are sticky, so the nominal interest rate affects the real interest rate. This, in turn, affects 0 ζπt+1
demand, and thus inflation through the “Phillips effect.” Suppose the reaction function,  
 0   ζ yt+1
 
,

also called simple policy rule, of the central bank is a “Taylor rule”  0  it +  0
  
 (6.27)
   
1
γ 0
i t = χ πt + υyt . (6.25)
with  
This is a sub-optimal commitment policy. It is a commitment rule since the policy setter επ t
will stick to this rule, even if it would be optimal to deviate from it in certain states. The i ε yt
h 
0 0 χ υ .
 
it =  (6.28)
optimal commitment rule, however, would not restrict the decision rule to be a function 
 πt 

of yt and πt only. yt
Note that there is no money demand function in this model. The reason is that mone-
This system is in state space form and could be summarized as
tary policy is specified in terms of the interest rate, so the money stock becomes demand " # " #
determined (the money supply curve is flat at the chosen nominal interest rate). Of course, x1t+1 x1t
Ã0 = Ã + B̃i t + ξ̃t+1 , and (6.29)
in order for the central bank to control anything of importance, there must be a demand Et x2t+1 x2t
" #
for money. The money demand function could be added to the model, but its only role is x1t
i t = −F . (6.30)
to determine the money stock. x2t
Suppose the shocks in (6.23) and (6.24) follow
where x1t is a vector of predetermined variables (here επt and ε yt , which happens to
επt+1 = τπ επt + ζπt+1 be exogenous, but also endogenous variables can be predetermined) and x2t a vector of
ε yt+1 = τ y ε yt + ζ yt+1 . (6.26) forward looking variables (here πt and yt ). Premultiply (6.29) with Ã−1
0 to get
" # " #
x1t+1 x1t
=A + Bi t + ξt+1 , where (6.31)
Et x2t+1 x2t
 
0 Ã, B = Ã0 B̃, and Cov (ξt ) = Ã0 Cov ξ̃t Ã0 .
A = Ã−1 −1 −1 −10
(6.32)

By using the policy rule (6.30) in (6.31) we get

" # " #
x1t+1 x1t
= (A − B F) + ξt+1 . (6.33)
Et x2t+1 x2t

98 99
 This system of expectational difference equations (with stable and unstable roots) can a. Baseline model b. Large inflation coefficient
be solved in several different ways. For instance, a decomposition of A − B F in terms of 4 4
π
eigenvalues and eigenvectors will work if the latter are linearly independent. Otherwise, 2 y 2
other techniques must be used (see, for instance, Söderlind (1999)). A necessary condition i
0 0
for a unique saddle path equilibrium is that A − B F has as many stable roots (inside the
unit circle) as there are predetermined variables (that is, elements in x1t ). −2 −2
To solve the model numerically, parameter values are needed. The following values −2 0 2 4 6 8 −2 0 2 4 6 8
have been used in most of Figures 6.2-6.4 (exceptions are indicated) period period

β δ φ γ τπ τ y υ χ λ y λi
0.99 2.25 2/7 2 0.5 0.5 0.5 1.5 0.5 0 c. Large output coefficient Persistent price shock: simple policy rule
4
The choice of δ implies relatively little price stickiness. The choice of φ means that a 1%
2
increase in aggregate demand leads to a desired increase of the relative price of 2/7%. The
choice of the relative risk aversion γ implies an elasticity of intertemporal substitution of 0

1/2. The υ and χ are those advocated by Taylor. The loss function parameters (see next −2
section) means that inflation is twice as important as output, and that the policy maker
−2 0 2 4 6 8
does not care about fluctuations in the nominal interest rate. period
The first subfigure in Figure 6.2 illustrates how the model with the policy rule (6.25)
works. An inflation shock in period t = 0 increases inflation. The policy maker reacts by
Figure 6.2: Impulse responses to price shock; simple policy rule
raising the nominal interest even more in order to increase the real interest rate. This, in
turn, has a negative effect on output and therefore on inflation via the “Phillips curve.” The
as follows: guess the coefficients υ and χ, solve the model, use the time series represen-
central bank creates a recession to bring down inflation. The other subfigures illustrates
tation of the model to calculate the loss function value. Then try other coefficients υ and
what happens if the coefficients in the reaction function (6.25) are changed.
χ, and see if they give a lower loss function value. Continue until the best coefficients
have been found.
6.3.2 Optimal Monetary Policy
The unrestricted optimal commitment policy and the optimal discretionary policy rule
Suppose the central bank’s loss function is are a bit harder to find. Methods for doing that are discussed in, among other places,
∞ Söderlind (1999).
X
Et β s L t+s , where (6.34) Figure 6.3 compares the equilibria under the simple policy rule, unrestricted optimal
s=0 commitment rule, and optimal discretionary rule, when it is assumed that π ∗ = y ∗ = 0.

2
2
2
L t+s = πt+s − π ∗ + λ y yt+s − y ∗ + λi i t+s − i ∗ . (6.35) It is clear that the optimal commitment rule achieves a much more stable inflation and
output, in spite of a less vigorous increase in the nominal interest rate. This is achieved by
A particularly straightforward way to proceed is to optimize (6.34), by restricting the
credibly promising to keep interest rates high in the future (and even raise further), which
policy rule to be of the simple form discussed above, (6.25). Optimization then proceeds
gives expectations of lower future output and therefore future inflation. This, in turn,

100 101
 a. Simple policy rule b. Commitment policy a. Simple policy rule b. Commitment policy
4 4 4 4
π π
2 y 2 2 y 2
i i
0 0 0 0

−2 −2 −2 −2

−2 0 2 4 6 8 −2 0 2 4 6 8 −2 0 2 4 6 8 −2 0 2 4 6 8
period period period period

c. Discretionary policy Persistent price shocks c. Discretionary policy Persistent demand shocks
4 4

2 2

0 0

−2 −2

−2 0 2 4 6 8 −2 0 2 4 6 8
period period

Figure 6.3: Impulse responses to price shock: simple rule, optimal commitment policy, Figure 6.4: Impulse responses to positive demand shock: simple rule, optimal commit-
and discretionary policy ment policy, and discretionary policy

gives lower inflation and output today. The discretionary equilibrium is fairly similar to
the simple rule in this model. Note that there is no constant “inflation bias” when target
levels are at their natural levels (zero) as they are in these figures. The discretionary rule is
still different from the commitment rule (they are, after all, outcomes of different games).
The intuition is that there is a time-varying “bias” since the conditional expectations of
output and inflation in the next periods (their “conditional natural rates”) typically differ
from the target rates (here zero).
Figure 6.4 makes the same type of comparison, but for a positive demand shock, −ε yt .
In this case, both optimal rules “kill” the demand shock, which is seen almost directly
from (6.24): any shock ε yt could be met by increasing i t by γ ε yt . In this way output is
unaffected by the shock, and there will then be no effect on inflation either, since the only
way the demand shock can affect inflation is via output (see (6.23)). This is very similar
to the static model discussed above: the demand shock drives both prices and output in
the same direction and should, if possible, neutralized. Of course, the result hinges on
the assumption that the policy maker is not averse to movements in the nominal interest
rate, that is, λi = 0 in (6.35). (It can be shown that this case can be approximated in the
simple policy rule (6.25) by setting the coefficients very high.) Many studies indicate that
central banks are unwilling to let the nominal interest rate vary much. This is sometimes
interpreted as a concern for the banking sector, and sometimes as due to uncertainty about
the state of the economy and/or the effect of policy changes on output/inflation. In any
case, λi > 0 is often necessary in order to make this type of model fit the observed
variability in nominal interest rates.

102 103
A Derivations of the Aggregate Demand Equation King, R. G., 1993, “Will the New Keynesian Macroeconomics Resurrect the IS-LM
Model?,” Journal of Economic Perspectives, 7, 67–82.
The period utility function is
Mishkin, F. S., 1997, The Economics of Money, Banking, and Financial Markets,
At 1−γ
U (Ct ) = C , (A.1) Addison-Wesley, Reading, Massachusetts, 5th edn.
1−γ t
where At is a taste shift parameter. The Euler equation for optimal consumption is Obstfeldt, M., and K. Rogoff, 1996, Foundations of International Macroeconomics, MIT
Press.
∂U (Ct ) ∂U (Ct+1 )
 
= βEt Q t+1 , (A.2)
∂Ct ∂Ct+1 Romer, D., 1996, Advanced Macroeconomics, McGraw-Hill.
where Q t+1 is the gross real return. Rotemberg, J. J., 1987, “New Keynesian Microfoundations,” in Stanley Fischer (ed.),
The marginal utility of Ct is NBER Macroeconomics Annual . pp. 69–104, NBER.
∂U (Ct ) −γ
= At C t , (A.3) Söderlind, P., 1999, “Solution and Estimation of RE Macromodels with Optimal Policy,”
∂Ct
European Economic Review, 43, 813–823.
so the optimality condition can be written
Walsh, C. E., 1998, Monetary Theory and Policy, MIT Press, Cambridge, Massachusetts.
At+1 Ct+1 −γ
 
1 = βEt Q t+1
At Ct
= βEt exp (ln Q t+1 + 1 ln At+1 − γ ln Ct+1 + γ ln Ct ) . (A.4)

Assume that ln Q t+1 , ln At+1 , and ln Ct+1 are jointly normally distributed. (Recall Eexp (x) =
exp (Ex + Var (x) /2) is x is normally distributed.) Take logs of (A.4) and rewrite it as

0 = ln β + Et ln Q t+1 + Et 1 ln At+1 − γ Et ln Ct+1 + γ ln Ct

+ Vart (ln Q t+1 + ln At+1 − γ ln Ct+1 ) /2, or (A.5)
1 1
Et ln Ct+1 = ln Ct + Et ln Q t+1 + Et z t+1 ,
γ γ
where Et z t+1 = ln β+Et 1 ln At+1 +Vart (.). The most important part of Et z t+1 is Et 1 ln At+1 .
If ln At+1 = ρ ln At + u t+1 , then Et 1 ln At+1 = (ρ − 1) ln At , so the AR(1) formulation
carries over to the expected change, but the sign is reversed if ρ > 0.

Bibliography
Blanchard, O. J., and S. Fischer, 1989, Lectures on Macroeconomics, MIT Press.

104 105

7 Empirical Measures of the Effect of Money on Output
Reference: Romer 5.6, Walsh (1998) 1, Mishkin (1997) 25, Isard (1995), Meese (1990),
and Obstfeldt and Rogoff (1996) 9.1
7.1 Some Stylized Facts about Money, Prices, and Exchange Rates
1. The correlation between long run inflation and money growth is almost one across
countries (BW Fig 8.9a).
2. The correlation between short run inflation and money growth is more uncertain
(BW Fig 10.10).
3. There is no clear long run correlation between inflation and the growth of real output
or between money growth and the growth of real output.
4. Money stock innovations and output innovations are correlated. Money stock changes
seems to lead output changes. Most of this correlation is between output and “inside
money” (created within the banking system, for instance, deposits).
5. PPP does not hold, except possibly for long horizons. Realignments seem to have
long lasting (although perhaps not permanent) effects on the real exchange rate.
(BW Fig 8.9b)
6. Countries with weak current accounts, and rapidly expanding money supply often
experience depreciation of the exchange rate.
7. Real exchange rates are much more volatile under flexible exchange rate regimes
than under fixed exchange rates. Real and nominal exchange rates are very strongly
correlated (this is evidence of monetary non-neutrality only if we can prove exis-
tence of important nominal shocks). (Isard Fig 3.2 and 4.2)
8. The log exchange rate behaves almost like a random walk (that is, ln St ≈ ln St−1 +
u t ). Equations for predicting ln St − ln St−1 typically have R 2 < 0.1.
106
9. The monetary contraction in many countries after the 1929 crash in the US can
probably be regarded as exogenous shifts. Countries which left the gold standard
early had weaker recessions. (OR Fig 9.10)
10. Most contracts are written in nominal terms, and prices are typically changed fairly
seldom—even at the fairly high inflation rates of the late 1970s. This seems to
change as we move into very high inflation rates. The way it changes is by indexa-
tion or “dollarization.”
11. Sharp exogenous monetary contractions (or a sudden and unexpected increase in
the short interest rates by the central bank) seems to have an effect on output and
employment which may last for years. (Walsh Fig 1.3)
7.2 Early Studies of the Effect of Money on Output
Early Keynesians (until the 1960s, say) thought that money has little effect on output.
There were several reasons for this. First, nominal interest rates (on high grade bonds)
were very low during the Great Depression, but that did not appear to boost output. Sec-
ond, investment and consumption regressions showed very little effect of nominal interest
rates.
The idea that the Great Depression was a period loose monetary policy was heavily
challenged by Friedman and Schwartz (1963a). They showed that the decline in money
supply was the largest ever in US history. (A possible counter argument to this is that the
monetary base changed fairly little, and that most of the change in the money aggregates
were due to the fact that the public chose to hold more cash and less deposits, and that
banks chose to hold more reserves.)
Another weak spot of the early Keynesian interpretation of the Great Depression is
that it is based on low nominal interest rates. Prices were falling, so the real interest rates
were actually very high, perhaps as high as 10%, which could be interpreted as a very
tight monetary policy.
107
7.3 Early Monetarist Studies of the Effect of Money on Output 7.3.2 On the Interpretation of Cov(yt , m t ) I: Reverse Causality

7.3.1 Friedman&Schwartz and St. Louis Equations The problem with a causal interpretation of the correlation between money and output,
or of the St. Louis equation, is that most of the correlation between money and output is
Friedman and Schwartz (1963a) and Friedman and Schwartz (1963b) study 100 years between output and “inside money” (deposits which is money created within the private
of US data and find that money aggregates lead output, in the sense that all recessions banking system, as opposed to the monetary base which is outside money).
were preceded by declining money growth rates. However, the response to money growth It is possible that banks extend more loans (which generates deposits) as the business
changes showed “long and variable lags.” They also argue that many of the money sup- conditions are about to pick up. The correlation between money and output is then due to
ply changes can be regarded as exogenous with respect to output (changes within the reverse causality as discussed in King and Plosser (1984). The idea is that money may not
monetary sector). have any effect on output, but output affects money aggregates positively, which explains
The St. Louis equation (see, for instance, Andersen and Jordan (1968)) is a regres- the positive correlation of output and money. For this to make sense, it must be the case
sion of output (growth) on current and lagged money (growth) and perhaps some other that the central bank cannot, or does not want to, control the broad monetary aggregates.
variables. This can be thought of as a formalization of the approach of Friedman and
Schwartz, although no attention is paid to whether the money supply changes are exoge- Example 33 (Regressing output on money, two-way causality.) Suppose the structural
nous or not. In its simplest form it is model of output and money is
X
yt = αs m t−s + εt , (7.1) yt = βm t + u yt
s=0
m t = γ yt + u mt ,
and the αs coefficients are sometimes interpreted as the effect of the money stock, m t−s ,
on output, yt . (Initially, St. Louis equations were used to explain nominal output, but here where the shocks are assumed to be uncorrelated. Output and money are here allowed to
the focus is on real output.) depend on each other (in the same period). The reduced form is
The St. Louis equation is not a structural model; it is a reduced form. Monetarists " # " #" #
yt 1 1 β u yt
would perhaps argue that the transmission mechanism from money to output is very com- = .
mt 1 − βγ γ 1 u mt
plex, and that it makes sense to use (7.1) since it can potentially summarize the effects.
Keynesians would perhaps be more “structural” in the sense that their view of the trans- Suppose we run a very simple St. Louis equation
mission mechanism is quite clear: money supply affects the interest rate (the LM equa-
yt = αm t + εt ,
tion), which in turn affects output (IS equation).
Any causal interpretation of the correlation between money and output, or of the St.
Louis equation relies on the assumption that most movements in the money stock are due
exogenous forces and not due to changes in output. These exogenous forces could be
policy shocks or shifts in money demand which are not caused by output.

108 109
The least squares (LS) estimate of α is (in probability limit, plim) 7.3.3 On the Interpretation of Cov(yt , m t ) II: Common Driving Force
Cov (m t , yt ) Instead of assuming that output affects money stock directly, it may be that there is a third
plim α̂ L S =
Var (m t ) variable which drives both output and money. This will also make the interpretation of
Cov γ u yt + u mt , u yt + βu mt


= money-output correlations very murky, since it gives an omitted-variables bias.
Var γ u yt + u mt

γ Var u yt + βVar (u mt )

Example 37 (Regressing output on money, unobservable driving force.) Suppose the
= 2 structural model of output and money is
γ Var u yt + Var (u mt )

γ Var u yt /Var (u mt ) + β


= 2 . m t = z t + u mt
γ Var u yt /Var (u mt ) + 1


yt = βm t + κz t + u yt
Example 34 (Exogenous money supply.) If m t is exogenous, γ = 0, then plim α̂ L S = β = (κ + β) z t + u yt + βu mt
in Example 33 and the regression coefficient captures the effect of money shocks on output.
This is the interpretation in Friedman and Schwartz (1963a). We get the same result if where the shocks are uncorrelated with each other and with z t . Money affects output if
Var u yt /Var(u mt ) → 0, that is, when most of the movements in output (and money) is β 6 = 0, but output does not affect money. However, both money and output are driven by

caused by the exogenous money shocks, so money is once again essentially exogenous. the common factor z t . The LS estimate of α in the St. Louis equation, yt = αm t + εt , is
then
Example 35 (Output shocks dominate.) Conversely, Var u yt /Var(u mt ) → ∞ gives


Cov (m t , yt )
plim α̂ L S → 1/γ in Example 33 (use l’Hôpital’s rule to show this), so the regression plim α̂ L S =
Var (m t )
coefficient merely reflects how money (and output) are both driven by output shocks (“re- Cov z t + u mt , (κ + β) z t + u yt + βu mt


=
verse causality”). Var (z t + u mt )
(κ + β) Var (z t ) + βVar (u mt )
The reverse causality story can be turned on its head, however. Suppose money do =
Var (z t ) + Var (u mt )
have effect on output, but that the central bank tries to stabilize output, that is, output has (κ + β) Var (z t ) /Var (u mt ) + β
= .
a negative effect on money supply. In this case, the correlation of money and output will Var (z t ) /Var (u mt ) + 1
underestimate the effect of money on output. This equals β only if z t is (effectively) a constant, Var(z t ) /Var(u mt ) = 0, or if output is
not affected by z t , κ = 0, so there is no common driving force.
Example 36 (Countercyclical policy.) From the reduced form in Example 33, we see that
output follows Example 38 (Unobservable driving force and “reverse causality.”) Suppose β = 0 in
1 β
yt = u yt + u mt . Example 37, so money has no effect on output (nor has output any effect on money). In
1 − βγ 1 − βγ
this case, the estimate of α in the St. Louis equation, yt = αm t + εt , becomes
Suppose β > 0, then a negative γ makes the effect of an output shock small. This gives
plim α̂ L S < β, so the St. Louis equation has a negative bias in the direct effect of money κVar (z t ) /Var (u mt )
plim α̂ L S = ,
on output. Var (z t ) /Var (u mt ) + 1
which has the same sign as κ. If we interpret yt as output in the next period, which
thus depends on today’s z t , then we have the case of King and Plosser (1984). Their

110 111
mechanism is that z t signals high future productivity, which leads to more purchases of Run a regression m t = λAt + ξt , where we get from the reduced form that
production factors today (needs to be accumulated in advance). This is a version of the Cov(At , m t )
traditional “reverse causality,” with the twist that future output affects today’s money plim λ =
Var (At )
demand. γ
Cov(At , 1−βγ u yt + 1
1−βγ At + 1−βγ εmt )
1
=
Var (At )
Example 39 (Countercyclical policy.) Suppose Var(u yt ) =Var(u mt ) = 0 in Example 37
1
and that the central bank sets κ = −β. This achieves complete stabilization of output, = ,
1 − βγ
and plim α̂ L S = 0 in the St. Louis equation. In this case, the successful monetary policy
since At is assumed to be uncorrelated with u yt and εmt . Form a fitted value of m t as
makes it look as if monetary policy cannot affect output.
m̂ t = λAt , or
1
One way of getting around the problem with the common driving force is to estimate m̂ t = At ,
1 − βγ
an extended St. Louis equation, where output is related to both money and a vector of
and use this instead of m t in the St. Louis regression, yt = αm t + εt . This gives a new
other variables capturing the driving force, xt ,
estimate
X X
αs m t−s + βs xt−s + εt . Cov m̂ t , yt


yt = (7.2)
s=0 s=0 plim α̂iv =

Var m̂ t
 
Of course, this approach assumes that we can observe the relevant variables and that they Cov 1−βγ1
At , u yt + β At + βεmt
are exogenous. The problem with a direct reverse causality (direct effect of output on =  
1
money, possibly with leads/lags) remains in this equation, however. Var 1−βγ At

7.3.4 St. Louis Equation with Instrumental Variables
Suppose we could get exogenous indicators of the exogenous movements in monetary
policy. As a first step, regress m t on the “instruments” and construct a series of fitted
policy, m̂ t . In a second step, use m̂ t instead of m t in a regression like (7.1). This is the
IV/2SLS method, which is consistent as long as the instruments are not driven by output.
The “trick” in the IV/2SLS method is to discard all variation in m t which is not driven
by the instruments. This side-steps all movements in m t which are due to reverse causality,
that is, due to the output shock. The regression will then look at how output moves in
response to the exogenous changes in money.
Example 40 (IV and the case of two-way causality.) Consider the model in Example 33,
and suppose we now that u mt = At +εmt , where At are observable shifts in money supply.
= β,
where we once again use the fact that At is uncorrelated with u yt and εmt . This is the
correct value.
Romer and Romer (1990) went through the Fed’s minutes to identify (exogenous)
policy shifts. They found six such policy shifts during the post war period. In each case,
short interest rates increased, while money aggregates and output decreased. They then
estimated a St. Louis equation with both least squares and instrumental variables, where
dummies for these episodes were used as instruments for money. They found that the
instrumental variables method gave larger effects of money on output, as expected if the
central bank uses money in a systematic way to stabilize output.
The analysis of Romer and Romer (1990) is very much like a formalization of what
Friedman and Schwartz (1963b) did: pick out a number of monetary contractions which
look exogenous and study what happens to output after that. Overall, the evidence from
the historical episodes in these and other studies point in the direction that money probably

112 113
have an effect on output. This conclusion is strengthened if we look at the reaction of 7.3.5 Dynamic Effects and Causality
output of large exchange rate realignments (another type of monetary policy).
Suppose the structural model consists of a reaction function where money is predeter-
Example 41 (Summary of Romer and Romer (1990) and Romer 232-236.) Main issue: mined
Xp Xp
to find instruments for exogenous shifts in monetary policy. The problem with possibly mt = γs yt−s + δs m t−s + u mt (7.3)
endogenous money is circumvented by focusing on episodes of exogenous (according to s=1 s=1

Romer and Romer) shifts in monetary policy: September 1955, December 1968, April and a somewhat extended St. Louis equation
1974, August 1978, and October 1979. According to the authors, these monetary con- p
X p
X
tractions were brought about by a desire to take down inflation, with little concern about yt = α0 m t + αs m t−s + βs yt−s + u yt . (7.4)
s=1 s=1
the effects on output. To investigate if there really were monetary contractions, univariate
forecasting equations for log money stock where estimated The shocks are assumed to be uncorrelated.
This is a “fully recursive” system of simultaneous equations, so least squares on (7.3)
24
and (7.4) separately is consistent. The reason is that the simultaneity problem is assumed
X
1m t = αs 1m t−s + u t
s=1 away: money is not contemporaneously affected by the output shock. It is also assumed
on monthly postwar data. Dynamic forecast for each period of 36 months after the 5 break that the lagged money and output capture all relevant common driving forces, so there is
dates indicate that the money stock were a lot lower (in data) than predicted: there seem no omitted-variables bias.
to have been contractions. Also, the interest rates show fairly consistent increases over However, if we care about more than just the impact effect of money supply shocks,
the same 36 months, so any effect on output could be consistent with either a monetarist or then money is endogenous in the economic sense since we have the following chain of
a Keynesian model. To see if theses contractions mattered for output, a St. Louis equation effects: u mt → m t → yt → m t+1 → yt+1 →... We therefore need to estimate both
was estimated equations in order to trace out the effect of a monetary policy shock on output. This is the
X24 X24 VAR approach discussed below.
1yt = a + bt + ci 1yt−s + di 1m t−s ,
s=1 s=0
with OLS and instrumental variables (IV). The instruments were a constant, a trend, 7.4 Unanticipated or Anticipated Money∗
1yt−s , 1m t−s , and {P St−s }36s=0 , where P St = 1 if t is one of the five policy shift dates,
Reference: Romer 6.4, Mishkin (1983) 6, and Barro (1977).
and zero otherwise. If m t is affected (negatively - to stabilize output) by Yt , OLS on the
Both the new monetarist (Lucas’ model for the Phillips curve ) and new Keynesians
output equation gives a downward bias in di . The IV approach should give consistent es-
(“micro based” models of nominal rigidities) emphasize the distinction between antici-
timates if the P St are not affected by output (the policy shifts were exogenous with respect
pated and unanticipated policy changes. The theoretical predictions, based on rational
to output, driven by concern about inflation, and inflation does not affect output per se),
expectations, are that anticipated policy changes should have no or only small effects on
and if P St affects output via money only (probably reasonable). The result is that d̂ I V is
output, while unanticipated changes could have large effects.
larger than d̂ O L S .
For simplicity, assume that the structural model for output is
p
X
yt = αs (m t−s − Et−s−1 m t−s ) + u yt , (7.5)
s=0

114 115
so output depends on money stock surprises and an output shock, u yt . again. The two (structural, it is assumed) equations can be written
The money supply rule is assumed to depend on past information and a policy shock; " # " # " # " #
mt m t−1 m t− p u mt
money supply is predetermined in relation to output B0 = B1 + ... + B p + , (7.8)
yt yt−1 yt− p u yt
m t = γ 0 z t−1 + u mt ⇒ Et−1 m t = γ 0 z t−1 . (7.6)
B0 , ..., B p are 2 × 2 matrices.
The output and policy shocks are uncorrelated. The vector z t−1 typically involves lagged The parameters (B0 , ..., B p , and the covariance matrix of the shocks) cannot be esti-
output, money supply, and some other variables. As in (7.3) and (7.4), the econometric mated without imposing some identifying restrictions. In fact, all data can tell us is the
simultaneity problem is assumed away by making money supply predetermined in relation parameters of the reduced form
to the output shock.
" # " # " #
mt m t−1 m t− p
Use the policy rule (7.6) in the output equation (7.5) = A1 + ... + A p + εt , (7.9)
yt yt−1 yt− p
k n
X
X The problem is that there may be many structural forms that generate the same reduced
yt = αs m t−s − γ 0 z t−s−1 + θ 0 z t−s−1 + u yt , (7.7)
s=0 s=0 form.
By (7.8), the reduced form can be written as
where θ = 0 if only unanticipated money matters. Suppose the system (7.6) and (7.7)
is estimated jointly and rational expectations is imposed (restricting γ to be the same in
" # " # " # " #
mt m t−1 m t− p u mt
−1
= B0 B1 + ... + B0 B p
−1 −1
+ B0 , (7.10)
both equations). It is then straightforward to test if θ = 0. Mishkin’s results indicate that yt yt−1 yt− p u yt
anticipated policy does matter.
so
Under the maintained hypothesis that only unanticipated money matters, only the αs " #!
coefficients are needed in order to study the effect on money on output. This is different u mt  0
Ai = B0−1 Bi for i = 1, ..., p and Cov (εt ) = B0−1 Cov B0−1 . (7.11)
from (7.3) and (7.4), where we needed the whole system. The reason is that in (7.5)-(7.6) u yt
the feedback from yt to m t+1 (due to an initial money supply shock u mt ) has no effect on
In the structural form (7.8), there are (1 + p) 4 coefficients in B0 , ..., B p and 3 parameters
yt+1 .
in covariance matrix of the structural shocks. In the reduced form (7.10), there are p4
coefficients in A1 , ..., A p and 3 parameters in covariance matrix of the reduced form
7.5 VAR Studies shocks. We therefore need to impose at least 4 restrictions to calculate the parameters
in the structural form.
7.5.1 VAR Models and Simultaneous Equations Systems∗
The following is a common set of restrictions. First, the structural shocks are un-
The VAR approach is an attempt to capture the main time series properties of money correlated (one restriction, the off-diagonal element in the covariance matrix is zero).
and output (and sometimes other variables) at the same time as enough restrictions are This means that the structural shocks have an economic interpretation as money or output
imposed to identify exogenous policy shifts. It is basically an attempt to estimate a system shocks. Second, the diagonal elements of B0 are unity (two restrictions); alternatively we
of simultaneous structural equations. could assume that the variances of the structural shocks are unity. Third, B0 is triangu-
For instance, (7.3) and (7.4) is a typical VAR model. In order to illustrate how VAR lar. Often (see, for instance, Sims (1980))), the assumption has been that money is not
models are handled, we look at that simple bivariate system of output and money once

116 117
contemporaneously affected by output, so B0 has the form
" #
1 0
B0 = . (7.12)
−α0 1
Using (7.12) in (7.8) gives us a system on the same form as (7.3) and (7.4). As
discussed before, these equations can be estimated with LS as they stand. Alternatively,
the reduced form (7.9) can be estimated with LS. Imposing the assumptions allows us to
solve for the structural parameters (typically a matter of solving non-linear equations, but
can be simplified by using some straightforward matrix decompositions like the Cholesky
decomposition).
This illustrates that the VAR does not allow us to escape the tricky question of endoge-
nous money, or more generally, monetary policy. The simultaneous equations bias may
therefore affect the VAR estimate—if the identifying assumptions we make are wrong.
Including lagged money and output in both equations is an attempt to control for common
movements in money and movements which are driven common factors (to get away from
a potential omitted-variables bias).
Once we have an estimate of the structural form (7.8), we may trace out the effect on,
for instance, output of shocks to monetary policy (“impulse response function”). We may
also calculate how large a fraction of the variance of the forecast error of output that is
explained by the monetary policy shocks (“variance decomposition”).
7.5.2 Typical Results from VAR Studies of Money and Output
The typical result for the US on quarterly data for the last 30 years or so is that output has
a humped-shaped response to u mt which may last for several years. However, monetary
policy shocks seems to have accounted for a fairly small fraction of the variance of output,
in particular after 1982. This does not, of course, mean that systematic monetary policy
has not been important or that monetary policy shocks cannot be important. For the latter,
the impulse response function is much more informative than the variance decomposition.
It is unfortunate that the VAR analysis typically says very little about the importance of
the systematic (feedback) part of policy, which by many is believed to be very important
(partly in opposition to the idea that only unanticipated money matters).
Some authors (for instance, Bernanke and Blinder (1992)) argue that M1 is not a good
proxy for the monetary policy instrument, and that a short nominal interest rate should
118
be used instead. First, there is evidence (see, for instance, Sims (1980)) that if output,
money, and the nominal interest rate are included in a VAR, then money can no longer help
predict output, but that interest rates help predict both output and money. (This suggests
that much of the movements in monetary aggregates are endogenous, not exogenous as
often assumed in macro models of monetary policy.) Second, the impulse responses to
money aggregates like US M1 is often weird: a positive innovation in M1 gives a decline
in output and an increase in nominal interest rates (see, for instance, Eichenbaum (1992)).
In contrast, a positive shock to the federal funds rate gives decline in output, which seems
much more reasonable. Third, many analysts argue that most central banks discuss and
set monetary policy in terms of a short interest rate.
Often, the dynamic response to a policy shock (stricter policy) is that the price level
increases instead of decreases: the price puzzle. This is often the case when a short interest
rate is taken to be the policy instrument. The reason is probably that the VAR contains too
little information compared to what the policy makers use. Including a commodity price
“solves” the puzzle. The interpretation is that the central bank reacts to commodity price
increases (by raising the interest rate/decreasing money supply) since they signal future
inflation. Suppose the monetary policy is unable to “kill” the inflation impulse completely.
Unless you control for the commodity prices, it will appear as if tighter monetary policy
leads to higher inflation. (See Walsh Fig 1.4)
Critique against VAR models: too little forward looking information included (asset
prices?), policy shocks differ wildly between different studies, relatively little information
about the effect of systematic policy, what if policy changes? (Lucas critique).
7.6 Structural Models of Monetary Policy
Reference: Fuhrer and Moore (1995), Fuhrer (1997), Söderlind (2000), and Clarida, Galı́,
and Gertler (1998).
Another line of research is to estimate a structural economic model directly (although
the requirement for the label “structural” may have shifted over time). Of course, there
is a long tradition of estimating AS-AD (IS-LM) models with adaptive expectations. Re-
cently, this have gained new popularity, but we have also seen a number of papers estimat-
ing similar models while allowing for rational expectations. Many central banks still use
fairly large macro models, even if there is a tendency towards smaller models (in order to
119
handle rational expectations, among other things).
Consider the simple model
πt = βEt πt+1 + δφyt + δεπt
1
Et yt+1 = yt + (i t − Et πt+1 ) + ε yt
γ
i t = χπt + υyt + εit .
The first equation comes from a Calvo model of price setting for a firm under monopolistic
competition; the second from the intertemporal optimality condition for a consumers (plus
the assumption that consumption equals output); and the third is Taylor’s policy rule,
which describes how the central banks sets the short nominal interest rate.
It is clear that this is a complicated model to estimate: there is plenty of simultaneity,
and expectations about future values are needed.
This model can be estimated by maximum likelihood by specifying the distribution
of the shocks (επ t , ε yt , and εit ). The MLE is found by iteration on the following steps
(i) guess a vector of parameters (β, δφ, γ , χ, υ, and the variances of the three shocks);
(ii) solve for the equilibrium and times series process (of πt , yt , and i t ); (iii) evaluate the
likelihood function; (iv) improve the guess of the parameter vector. This gives a set of
estimates where rational (model consistent) expectations have been imposed. A possible
alternative is to use survey information as proxies for some or all expectations.
Another approach is taken by Clarida, Galı́, and Gertler (1998) who want to estimate
the monetary policy rule (“reaction function”) for several countries. They specify a policy
rule for the short interest rate, i t , of the form
i t = β Et πt+12 + γ Et yt + ρi t−1 + u t ,
where Et yt is the best estimate of the current output gap and where πt+12 is the inflation
over the next twelve months. This formulation is can be seen as an approximation of the
optimal policy in many models where there is some price stickiness and where the central
bank wants to stabilize inflation and output, but also avoiding excessive movements in the
short interest rate. The equation is estimated with an instrumental variables method. To
see why that makes sense, not that we can rewrite (7.16) as
i t = βπt+12 + γ yt + ρi t−1 + u t + εt+n ,
where εt+n is a linear combination of the surprise in inflation, πt+12 − Et πt+12 , and in the
output gap, yt −Et yt . The new residual in (7.17), u t +εt+n , is clearly not uncorrelated with
the regressors, so we need to apply an instrumental variables method. All information at
(7.13) t or earlier should be valid instruments.
(7.14) Clearly, this approach allows us to understand the monetary policy rule only. To see
how a policy change, for instance, a shock u t to (7.16) affects output and inflation, we
(7.15)
have to estimate the rest of the model.
Bibliography
Andersen, L. C., and J. L. Jordan, 1968, “Monetary and Fiscal Actions: A Test of Their
Relative Importance in Economic Stabilization,” Federal Reserve Bank of St. Louis
Review, 50, 11–24.
Barro, R. J., 1977, “Unanticipated Money Growth and Unemployment in the United
States,” American Economic Review, 67, 101–115.
Bernanke, B. S., and A. S. Blinder, 1992, “The Federal Funds Rate and the Channels of
Monetary Transmission,” American Economic Review, 82, 901–921.
Clarida, R., J. Galı́, and M. Gertler, 1998, “Monetary Policy Rules in Practice: Some
International Evidence,” European Economic Review, 42, 1033–1067.
Eichenbaum, M., 1992, “Comment on ’Interpreting the Macroeconomic Time Series
Facts: The Effects of Monetary Policy’ by Christopher Sims,” European Economic
Review, 36, 1001–1011.
(7.16)
Friedman, M., and A. J. Schwartz, 1963a, A Monetary History of the United States, 1867-
1960, Princeton University Press, Princeton.
Friedman, M., and A. J. Schwartz, 1963b, “Money and Business Cycles,” Review of Eco-
nomics and Statistics, 45, 32–64.
Fuhrer, J., and G. Moore, 1995, “Inflation Persistence,” Quarterly Journal of Economics,
110, 127–159.
(7.17)
120 121
Fuhrer, J. C., 1997, “Inflation/Output Variance Trade-Offs and Optimal Monetary Policy,”
Journal of Money, Credit, and Banking, 29, 214–234.

Isard, P., 1995, Exchange Rate Economics, Cambridge University Press.
King, R. G., and C. Plosser, 1984, “Money, Credit and Prices in a Real Business Cycle
Model,” American Economic Review, 74, 363–380.
Meese, R. A., 1990, “Currency Fluctuations in the Post-Bretton Woods Era,” Journal of
Economic Perspectives, 4, 117–133.
Mishkin, F. S., 1983, A Rational Expectations Approach to Macroeconometrics, NBER.
0 Reading List
Main references: Romer (1996) (Romer), Blanchard and Fischer (1989) (BF), and Ob-
stfeldt and Rogoff (1996) (OR). For an introduction to many of the issues, see Burda
and Wyplosz (1997) (BW). Walsh (1998) (Walsh) is a more advanced text, and is recom-
mended for further study.
Papers marked with (∗ ) are required reading.

Mishkin, F. S., 1997, The Economics of Money, Banking, and Financial Markets, 0.1 Money Supply and Demand
Addison-Wesley, Reading, Massachusetts, 5th edn.
1. ∗ Lecture notes
Obstfeldt, M., and K. Rogoff, 1996, Foundations of International Macroeconomics, MIT
Press. 2. ∗ OR 8.1, 8.3.1-4 (MIU), and 9.1 (stylized facts) or ∗ Walsh 2.3.1 (MIU)

Romer, C. D., and D. H. Romer, 1990, “New Evidence on the Monetary Transmission 3. ∗ Romer 9.8 (cost of inflation)
Mechanism,” Brookings Papers on Economic Activity, 1, 149–213. 4. Lucas (2000) (cost of inflation)
Sims, C. A., 1980, “Macroeconomics and Reality,” Econometrica, 48, 1–48. 5. BF 4.2 and 4.5 (MIU)
Söderlind, P., 2000, “Monetary Policy and the Fisher Effect,” Journal of Policy Mod-
Keywords: money multiplier, central bank intervention, traditional money demand
eling, Forthcoming, also available as Working Paper No. 159, Stockholm School of
equations, money in the utility function, Friedman’s rule.
Economics.

Walsh, C. E., 1998, Monetary Theory and Policy, MIT Press, Cambridge, Massachusetts. 0.2 Price Level and Nominal Assets

1. ∗ Lecture notes

2. ∗ OR 8.2 (seignorage) or ∗ Walsh 4.3 (seignorage)

3. ∗ OR 8.4.1 and 8.4.3-4 (exchange rates)

4. ∗ Meese (1990) (exchange rate regressions)

5. BF 4.7 and 5.1 (seignorage)

122 123
 6. Romer 9.7 (seignorage)
7. Isard (1995) 4 (PPP), 5 (UIP), and 8 (exchange rate regressions)
Keywords: price level in general equilibrium, superneutrality of money, Cagan’s
model with rational expectations, seignorage, exchange rate determination from money
demand and UIP
0.3 Money and Prices in RBC Models
1. ∗ Lecture notes
2. ∗ Bénassy (1995) (Long-Plosser model with money and predetermined wages)
3. Cooley and Hansen (1995) (RBC model with money and predetermined wages)
4. King and Plosser (1984) (reverse causality)
5. Walsh 3.3 (CIA) and 5.3.1 (wage rigidity in MIU models)
Keywords: RBC model with money and sticky prices, reverse causality, CIA.
0.4 Money and Monopolistic Competition
1. ∗ Lecture notes
2. ∗ OR 10.1 (GE with monopolistic competition)
3. ∗ Romer (1993) (overview of New Keynesian models)
4. ∗ King (1993) (overview of New Keynesian models)
5. BF 8.1 (GE with monopolistic competition)
6. Romer 6.6 and 6.10-15 (monopolistic competition, real rigidities)
7. BF 9.5 (real rigidities)
8. Walsh 5.3.2 (imperfect competition and price stickiness)
124
Keywords: general equilibrium in static model of monpolistic competition (Blanchard-
Kiyotaki), menu costs, Nash equilibria with/without sticky prices, importance of ”real
rigidities.”
0.5 Sticky Prices
1. ∗ Lecture notes
2. ∗ Rotemberg (1987) (adjustment costs for prices) or ∗ Walsh 5.5 (inflation persis-
tence)
3. ∗ Roberts (1995)
4. Romer 6.5-9 (staggered prices, Caplin-Spulber)
5. BF 8.2-4 (staggered prices, Ss, Caplin-Spulber)
Keywords: quadratic adjustment costs for prices (Rotemberg), Calvo’s model of price
changes, combining with “flex price” from monopolistic competition. (Advanced: Ss
rules)
0.6 Monetary Policy
1. ∗ Lecture notes
2. ∗ OR 9.4-5 (Barro-Gordon model) or ∗ Walsh 8.1-2 (Barro-Gordon)
3. ∗ Taylor (1995) (Empirical analysis of transmission mechanism)
4. ∗ Fischer (1996) (Costs of inflation)
5. ∗ Obstfeld and Rogoff (1995) (Mirage of fixed exchange rates)
6. Bernanke and Mishkin (1997) (inflation targeting)
7. Fuhrer (1997) (inflation/output trade-off)
8. Romer 5.1-5 (IS-LM) and 9.6 (What can policy accomplish?)
125
 9. BF 11.2 (traditional monetary policy issues) and 11.4 (Barro-Gordon model) Bibliography
10. Walsh 5.4 (macro model for policy analysis), 8.4-5 (institutions), and 10.5 (macro Bénassy, J.-P., 1995, “Money and Wage Contracts in an Optimizing Model of the Business
model for policy analysis again) Cycle,” Journal of Monetary Economics, 35, 303–315.

11. OR 9.2-3 (Dornbusch model) Bernanke, B., 1983, “Nonmonetary Effects of the Financial Crisis in the Propagation of
the Great Depression,” American Economic Reveiw, 73, 257–276.
Keywords: Mundell-Flemming model and choice of exchange rate regime, Barro-
Gordon model of monetary policy (discretion and commitment), recent models for mon- Bernanke, B. S., and M. Gertler, 1995, “Inside the Black Box: The Credit Channel of
etary policy, Monetary Policy Transmission,” Journal of Economic Perspectives, 9, 27–48.
Dornbusch model.
Bernanke, B. S., and F. S. Mishkin, 1997, “Inflation Targeting: A New Framework for
Monetary Policy,” Journal of Economic Perspectives, 11, 97–116.
0.7 Empirical Measures of the Effect of Money on Output
Blanchard, O. J., and S. Fischer, 1989, Lectures on Macroeconomics, MIT Press.
1. ∗ Lecture notes
Burda, M., and C. Wyplosz, 1997, Macroeconomics - A European Text, Oxford University
2. ∗ Walsh 1 (overview) Press, 2nd edn.

3. Romer 5.6 (selective overview) Cooley, T. F., and G. D. Hansen, 1995, “Money and the Business Cycle,” in Thomas F.
Cooley (ed.), Frontiers of Business Cycle Research, Princeton University Press, Prince-
Keywords: interpreting money-output correlations, anticipated or unanticipated money,
ton, New Jersey.
VAR studies, “case studies” (Romer-Romer).
Fischer, S., 1996, “Why Are Central Banks Pursuing Long-Run Price Stability,” in
Achieving Price Stability, pp. 7–34. Federal Reserve Bank of Kansas City.
0.8 The Transmission Mechanism from Monetary Policy to Output
Fuhrer, J. C., 1997, “Inflation/Output Variance Trade-Offs and Optimal Monetary Policy,”
1. Mishkin (1995)
Journal of Money, Credit, and Banking, 29, 214–234.
2. Walsh (1998) 7
Isard, P., 1995, Exchange Rate Economics, Cambridge University Press.
3. Bernanke and Gertler (1995)
King, R. G., 1993, “Will the New Keynesian Macroeconomics Resurrect the IS-LM
4. Bernanke (1983) Model?,” Journal of Economic Perspectives, 7, 67–82.

5. Romer and Romer (1990) King, R. G., and C. Plosser, 1984, “Money, Credit and Prices in a Real Business Cycle
Model,” American Economic Review, 74, 363–380.
6. Stiglitz and Weiss (1981)
Lucas, R. E., 2000, “Inflation and Welfare,” Econometrica, 68, 247–274.
Keywords: money view, lending view, credit rationing (Stiglitz-Weiss).

126 127
Meese, R. A., 1990, “Currency Fluctuations in the Post-Bretton Woods Era,” Journal of
Economic Perspectives, 4, 117–133.

Mishkin, F. S., 1995, “Symposium on the Monetary Transmission Mechanism,” Journal

of Economic Perspectives, 9, 3–10.

Obstfeld, M., and K. Rogoff, 1995, “The Mirage of Fixed Exchange Rates,” Journal of
Economic Perspectives, 9, 73–96.

Obstfeldt, M., and K. Rogoff, 1996, Foundations of International Macroeconomics, MIT

Press.

Roberts, J. M., 1995, “New Keynasian Economics and the Phillips Curve,” Journal of
Money, Credit, and Banking, 27, 975–984.

Romer, C. D., and D. H. Romer, 1990, “New Evidence on the Monetary Transmission
Mechanism,” Brookings Papers on Economic Activity, 1, 149–213.

Romer, D., 1993, “The New Keynesian Synthesis,” Journal of Economic Perspectives, 7,
5–22.

Romer, D., 1996, Advanced Macroeconomics, McGraw-Hill.

Rotemberg, J. J., 1987, “New Keynesian Microfoundations,” in Stanley Fischer (ed.),

NBER Macroeconomics Annual . pp. 69–104, NBER.

Stiglitz, J. E., and A. Weiss, 1981, “Credit Rationing in Markets with Imperfect Informa-
tion,” American Economic Review, 71, 393–410.

Taylor, J. B., 1995, “The Monetary Transmission Mechamism: An Empirical Frame-

work,” Journal of Economic Perspectives, 9, 11–26.

Walsh, C. E., 1998, Monetary Theory and Policy, MIT Press, Cambridge, Massachusetts.

128