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Principles of Econometrics, 4th Edition Chapter 9: Regression with Time Series Data:

Stationary Variables

Monetary Neutrality

Lucas (1996)

Sharif University of Technology Graduate School of Management and Economics

Macroeconomics Research Group

Monetary Neutrality

Navid Raeesi Fall 2013




Monetary Neutrality

What are we going to see?




Monetary Neutrality

Inflation and broad money growth




Monetary Neutrality

Money and Prices During Four Big Inflation Source: Sargent (1981)




Monetary Neutrality

Average Money Growth and Inflation (1960-90) Source: McCandless and Weber (1995)




Monetary Neutrality

Average money growth and growth in real output (1960-90) Source: McCandless and Weber (1995)




Monetary Neutrality

Inflation and unemployment in the United states Source: Friedman and Schawrtz (1963)




Monetary Neutrality

Money neutrality

Quantity theory of money in Hume’s words:

But money changes in reality do not occur by such means!

Is this a matter of exposition, or should we be concerned about it?

This is in fact a crucial question.

Introduction




Monetary Neutrality

Money in short-run, the initial effect of money monetary expansion in

Hume’s words:

But why does an early recipient of the new money “find everything at

the same price as formerly”?

Introduction




Monetary Neutrality

Developments of monetary economics since 1960s till today




The Ends of Four Big Inflations

Key components

Optimizing agents - �well defi�ned decision problems

General equilibrium perspective

Representative household

Takes prices as given and maximizes

Subject to

Firms

Firms maximize profits in competitive goods and factor markets,

subject to a production technology

A basic real business cycle (RBC) model





Market clearing:

Takes prices as given and maximizes

Subject to

Question: Hoe to incorporate Money?

To employ the neoclassical framework to analyze monetary

issues, a role for money must be specified so that the agents will

wish to hold positive quantities of money.

A basic real business cycle (RBC) model





Three general approaches to incorporating money into general

equilibrium models have been followed:

Assume that money yields direct utility by incorporating money

balances directly into the utility functions of the agents of the model

(Sidrauski 1967).

Impose transactions costs

Make asset exchanges costly (Baumol 1952, Tobin 1956)

Require that money be used for certain types of transactions

(Clower 1967)

Assume time and money can be combined to produce transaction

services that are necessary for obtaining consumption goods

Assume direct barter of commodities is costly (Kiyotaki and

Wright 1989).

Treat money like any other asset used to transfer resources

intertemporally (Samuelson 1958).

Incorporating money

Principles of Econometrics, 4th Edition Page 16 Chapter 9: Regression with Time Series Data:



Monetary Neutrality

Assumptions

People live for two periods: a young person can work and

produces goods, an old person likes to consume goods but has no

ability to produce them

No family structure

Constant population

If the good were storable,

Assuming that the good cannot be stored, the best one acting alone

can do is to enjoy leisure when young and never consume anything.

A Simple General Equilibrium Framework




Monetary Neutrality

Society as a whole should be able to do much better than that, by

somehow including the young to produce for the consumption of their

contemporary old:

Some institution is needed: a monetary system.

the failure of the autarchic allocation arises from the absence of

the double coincidence of wants that barter exchange requires.

If there were some paper money in circulation, initially in the hands

of the old, would the young accept these tokens –intrinsically useless-

and hence keep the value of tokens in terms of goods at any level

above zero?





Monetary Neutrality

If the money supply is constant and evenly distributed over the old in

the amount 𝑚 per person, then

Every one solves the problem

The equilibrium price will be 𝑝 = 𝑚 𝑛∗ .

The equilibrium is quantity-theoretic in Hume’s sense.

If 𝑚 is (somehow) increased, the equilibrium level will be

increased in the same proportion, and quantities of labor and

production will not be affected at all.





Monetary Neutrality

What if we consider monetary changes that differ from once-and-for-

all changes in the money stock?

Suppose money supply is to be augmented by the lump-sum transfer

𝑚(𝑥 − 1) to the young, then

Each young person solves the problem

The f.o.c. for this problem is





Monetary Neutrality

The rational expectation equilibrium of the model, Suppose money

supply is to be augmented by the lump-sum transfer 𝑚(𝑥 − 1) to the

young, then

Suppose that the price level is proportional to the money stock,

𝑝 = 𝑘𝑚, for some constant 𝑘, and labor is constant at some value

𝑛 , then the constant 𝑘 will evidently be 1 𝑛 .

Tomorrow's prices is then 𝑝′ = 𝑘𝑚𝑥 = 𝑚𝑥 𝑛 .

Thus, thee f.o.c. becomes

The quantity-theoretic predictions confirmed.

The role of inflation tax

Question: How might this OLG economy be modified so that a

monetary expansion will act as stimulus to production?

The role of uncertainty





Monetary Neutrality

In order to get an output effect from a monetary shock, it is not

enough simply to introduce uncertainty!

We need to imagine that exchange money for goods takes place in

some manner other than in a centralized Walrasian market.

Assume that the exchange occurs in two markets, each with different

number of goods suppliers.

The role of informational frictions

Why is it that people can not obtain that last bit of information that

would enable them to diagnose price movements accurately?

In reality, up-to-date information on the money supply does not

seem all that hard to come with.

A more abstract scenario (Lucas, 1972b)

Assume that old and young engage in some kind of trading game.





Monetary Neutrality

Other models that offer rationalization of a short-run monetary non-

neutrality in the sense of an increasing function 𝜑(𝑥):

Nominal prices are set in advance: Fischer (1977), Pheleps and

Taylor (1994), Taylor (1979), Svensson (1986)

Transfers are only gradually revealed: Eden (1994), Lucas and

Woodford (1994), Williamson (1995)

Other models that offer rationalization of a short-run monetary non-

neutrality in the sense of an increasing function 𝜑(𝑥):

Hume’s paradox has been resolved.

Does it matter which of these rationales is appealed to?





Monetary Neutrality

Conclusion



Thanks for Your Attention!

Macroeconomic Research Group

Monetary Neutrality

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