Monetary Model

Econ302, Fall 2004 Professor Lutz Hendricks,

August 19, 2004

What this chapter is about

Add money to the intertemporal model. Then we study: the eects of monetary policy, business cycles. .

What is Money?

Money is the set of assets that are commonly used to pay for transactions (the medium of exchange). Examples: Currency: bills and coins. Deposits held in checking accounts. Bills issued by certain banks in the 19th century. Cigarettes after World War II in Germany. Sea shells or certain stones in some early economies. The key feature of money is liquidity: money must be easy to transport, veriable. Most importantly: money must be accepted for transactions this is a social convention. The dividing line between money and non-monetary assets is arbitrary Are checkable money mutual fund accounts "money"? How much "liquidity" should we require to call an asset "money"? .

2.1

Measures of Money

The following is a list of commonly used "monetary aggregates:" Currency + Bank reserves held with the Fed + Checkable deposits + Money market accounts + Money market mutual funds + Certain liquid assets held by institutional investors

M0 M1 M2 M3

M0 is also called base money, high powered money, outside money. M0 is directly controlled by the Fed. .

2.2

Real and Nominal Interest Rates

Real interest rate: giving up one unit of C today yields (1 + r) units of C 0. Nominal interest rate: giving up one unit of money today yields (1 + R) units tomorrow. Both are related through the Fischer equation: 1 + R = (1 + r) (1 + i)
0 where i = P P P is the rate of ination.

(1)

Why is this true? Give up one unit of C today and invest P units of money. Tomorrow, receive P (1 + R) units of money. Purchase P (1 + R) =P 0 units of C 0. The real rate of return is: 1+r = .
C0 P (1 + R) =P 0 1+R = = C 1 1+i

Approximate Fischer equation: For small i and r: Real interest rate = nominal interest rate - ination rate

r=R

(2)

Example of a good approximation:

R = 0:06; i = 0:02. Exact:

1:06 = 1:039 1+r = 1:02 Approximate:

r = 0:06

(3)

0:02 = 0:04

(4)

Example of a poor approximation:

R = 0:20; i = 0:16. Exact:

1+r = Approximate:
r = 0:20

1:20 = 1:034 1:16 0:16 = 0:04

(5)

Model Structure

Start with the real model of the previous chapter. Add the requirement that all purchases must be paid for using money. The initial stock of money is given and held by the household. The government injects new money by purchasing goods in the market or by paying bond interest. .

The Timing

With the period, this is the sequence of events:

4.1

The Household

The household enters the period holding: Bonds B which pay nominal interest R . Money M . The household chooses C; l; B d; M d to maximize utility max U (C; l) subject to a budget constraint a cash-in-advance (CIA) constraint. .

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4.1.1

Budget constraint

Income in dollars:
P y = P w (h l) + P PT + R B

(6)

Initial assets: M

+B .

Spending: P C + B d + M d. Budget constraint:

d d PC + B y +M +B } | {z + M } = P | {z |{z} Spending Initial assets Income

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4.1.2

Cash-in-advance constraint

The reason for holding money in this economy is that purchases must be paid with money. At the beginning of the period, the household holds bonds B and money M . He receives additional money from the government: R B . Some money is spent on buying bonds: B d. When the credit market closes, the household holds

M =M

+ 1+R

Bd

(7)

The CIA constraint species that consumption and tax payments require money:
PC + PT M Bd

= M

+ 1+R

The CIA constraint binds, if the nominal interest rate is positive.

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4.1.3

Money demand

What are determinants of money demand? Lifetime wealth, because it aects consumption. The nominal interest rate: the opportunity cost of holding money. For simplicity we assume:
M d = P L( Y ; R )
+

This is not exactly right! Other factors that should matter include: Future income (! C ). Taxes (current and future). The real interest rate (r ! C ). .

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Government

The government combines the Treasury and the Fed. Budget constraint
P G + (1 + R )B

= PT + B + M

Enter the period with outstanding liabilities M Expenditures G and bond repayment 1 + R Revenues: Taxes: P T . New bonds issued: B . New money issued: M .

+B .
B .

M .

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Equilibrium

We simply add the money market to the Real Model studied earlier. Note: This is again not exactly right. For example: changes in monetary variables should aect consumption and leisure choice.

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6.1

Money market

Money supply is directly controlled by the government (M ). Money market clearing:

M = P L (Y; R)

(8)

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6.2

The Complete Model

We simply added money market clearing to the equilibrium conditions for the real model.

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Productivity Shocks

What are the eects of a temporary decline in z ? The real eects are the same as in the real model: Labor demand declines b/c M PN is lower. Labor supply increases (not by much; let s neglect that). Output drops for given inputs. Result: Y # and r ".

Stagation: A bad productivity shocks causes a recession combined with ination. Example: 1973 oil price shock. .

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Monetary Neutrality

What are the eects of monetary policy?

The experiment: Holding M unchanged, the government increases M in the current period. Assume that the new money is simply given to the households (helicopter drops).

Result: Money is neutral. This means: a one-time increase in M does not aect the equilibrium allocation (here: C; l; N; Y ). How do we see that money is neutral? Monetary variables do not appear in the labor or goods market clearing conditions. The model has a classical dichotomy: monetary variables do not aect real variables. M only aects the money market. .

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8.1

Eect of M on the money market

Money demand remains unchanged: Y and r are determined in the labor and goods markets. Money demand is linear in the price (real money demand is independent of P ). If (Y; r ) remain unchanged, an x% increase in M causes an x% increase in P . Real money balances (M=P ) are unchanged. .

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8.2

Why is money neutral?

An experiment: On a xed date, the government hands out 100 New Dollars for every Dollar held by any person. This is perfectly anticipated by all. Could there be real eects? No this amounts to using cents instead of dollars to denote prices. Sensible models have the property that changing the units in which money is denominated has no real eects. .

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8.3

Why might money not be neutral in practice?

The change in M may not be fully anticipated. If some contracts are written in nominal terms, they cannot adjust to ination. Money is not distributed by helicopter drops. In practice the Fed uses open market operations: it buys bonds using the new money ( B ). The Treasury can use new money to purchase goods ( G). .

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8.3.1

Is money neutral in practice?

The answer depends in large part on whether a monetary change was anticipated.

Example 1 Famous dis-ination episodes. Tightening the money supply usually reduces aggregate demand. But there are famous counter-examples: Germany after WW2.

Example 2 The Fed changes the Federal Funds Rate (its way of manipulating $M$). Typically the stock market falls. But sometimes there is no reaction the change was anticipated. .

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A key insight of monetary economics:

Monetary policy changes have real eects, but only to the extent that they come as surprises.

This raises many policy issues: Should the Fed follow monetary policy rules to make its actions predictable? Or should it use discretion to be able to manipulate real variables? Is the Fed responsible for business cycles? Or does the Fed help stabilize the economy? .

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Lucas Money Suprise Model

An illustration of how monetary policy can have real effects, if private agents do not anticipate Fed policy. We use the Monetary Model with one modication:

Households do not observe M; P; w; z in the current period.

The idea: Households cannot distinguish real shocks (z ) from monetary shocks (M ). When an M shock occurs, households mistake it for a z shock and respond by changing labor supply. .

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9.1

Eect of an M shock

With complete information: M expansion only causes ination P " and nominal wages rise (W = wP ). Households observe higher W , but do not know whether this is due to a z shock or an M shock. If it is a z shock, then w has gone up and household should work more: N s ". Therefore: Y s curve shifts out.

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9.2

Second round eects of M "

C increases due to lower r and higher Y . I increases due to lower r.

Money demand increases due to lower r and higher Y .

M s also rises. Therefore (?) P ".

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9.3

Policy Implications

Money is not neutral. Monetary policy can be used as stabilization policy. Monetary policy only works, if it can surprise the private sector. This is a typical feature of models where money is not neutral. Consistently surprising the private sector is hard to do! Monetary policy itself can be a source of instability. It might be optimal for monetary policy to follow a xed rule.