Theoretical Lecture 2

Today: Production, money and ination dynamics

Neutrality and superneutrality
Existence and stability of steady-state
Dynamic eects of stochastic money growth rate shocks

Production, Money and Ination

Basic set-up: Production economy, MIU set-up

First consider perfect foresight setting then think about stochastic settings
Households maximize:
V

=
:
:

tu (ct, mt+1/pt)

t=0
uc, um/p, uc,m/p

lim uc =

c0+

0, ucc, um/p,m/p 0

lim

m/p0+

um/p =

 subject to sequence of budget constraints:

(1 + it1) bt mt
yt + t + (1 ) kt +
+
pt
pt
m
b
ct + kt+1 + t+1 + t+1
pt
pt

b denotes nominal private debt only.

The government budget constraint is (note that are transfers):
pt t = Mt+1 Mt
Production: Firms are competitive and produce with a neoclassical technology:
yt = f (kt)
f (0) = 0, f 0, f 0
lim f = , lim f = 0

k0

 Bellmans equation for the households problem:

V (k, b, m) = max u

c, m /p + V k , b , m

(1 + i1) b m
st : f (k) + + (1 ) k +
+
p
p
m b

c+k +
+
p
p
The rst-order conditions are given as:
c :
k :
b :

uc c, m /p =

Vk k , b , m =

Vb k , b , m =

1 1

m : Vm k , b , m = um/p c, m /p
p p

and the envelope conditions are:

f (k) + (1 )

k : Vk (k, b, m) =
1 + i1
b : Vb (k, b, m) =
p
1
m : Vm (k, b, m) =
p
subject to transversality conditions for k, b, and m
Combining them we get that:
uc
um/p

c, m /p

(1 + r) =

c, m /p

uc (c, m/p)

uc c , m /p (1 + r)

f k + (1 )

i
=
1+i

p
(1 + r) = (1 + i)
p

where r is the net real interest rate.

real interest rate must now equal expected real return on capital

Steady-state properties:

Question: How is the steady-state aected by (a) the stock of money, and (b)
the money growth rate?

Assume that all variables are either constant or grow at constant rates in the
steady state. Growth rates are permitted for the money stock and for the price
level.

Denote steady-state values by the super script SS

For m/p to be constant, the money stock and the price level must grow at
the same rate - the ination rate must equal the money growth rate

 Later we will ask if there could be another equilibrium with a constant growth
rate of m/p
But now: assume that

ss

ss

ss
= p /p
= m /m
= gm

This means that we can write m/p ss = gm (m/p)ss

Next, since B is private debt, in the equilibrium we must have that B = 0 in

a representative agent setting

Finally, note that

ss

ss

m /p

(m/p)ss = (gm 1) (m/p)ss

 The rst-order conditions evaluated at the steady-state:

b : uc (css, gm (m/p)ss) = uc (css, gm (m/p)ss) (1 + rss)
: 1 + rss = 1/

: 1 + iss = gm/

ss
ss
ss
ss

ss
k : uc (c , gm (m/p) ) = uc (c , gm (m/p) ) f (k ) + (1 )

: f (kss) = 1/ (1 )
um/p (css, gm (m/p)ss)
gm/ 1
m :
=
uc (css, gm (m/p)ss)
gm/

goods market and government budget constraints:

css = f (kss) kss

ss = (gm 1) (m/p)ss

 Result 1: A once and for all change in the money stock changes the price level
one-for-one with the change in the money stock and leaves all real variables
unaected - NEUTRALITY

Result 2: A change in the money supply growth rate changes the ination
rate one-for-one and leaves all real variables apart from the real money demand
unaected - SUPERNEUTRALITY

Neutrality: (i) the price level enters only in the government budget constraint
and in the real money demand equation. (ii) The real money demand does
not depend on the stock of money. Thus, the only eect of a once and for
all change in the money stock that is consistent with the steady-state is to
multiply the price level with the proportional change in the money stock - else
the government budget constraint would not be satised.

 Superneutrality:
1. The steady-state capital stock is determined by the discount factor, the depreciation rate and the curvature of the production function. It does not depend
on the money growth rate.

2. It then follows that steady-state consumption is unaected as well.

3. The nominal interest rate must increase proportional with the increase in the
money growth rate since the real interest rate is independent of the money
growth rate.

4. Therefore, the only eect of a change in the money-growth rate is to change

the real money stock.

 Neutrality - in the long-run and in the short-run - is a general property of

exible price models

Short run non-neutrality - as we shall return to - occur in models with nominal

rigidities

Superneutrality is not general and is due to special assumptions that we made

above

 Generalization of the previous model: Labor-leisure choice

V

tu (ct, mt+1/pt, lt)

t=0

yt = f (kt, nt)
lt + nt = 1

The households problem is now:

V (k, b, m) = max u

c, m /p, 1 n + V k , b , m

(1 + i1) b m
st : f (k, n) + + (1 ) k +
+
p
p
m b

c+k +
+
p
p

 The rst-order conditions are the same as above and in addition:

ul

c, m /p, 1 n

= fn (k, n) uc

c, m /p, 1 n

sets the marginal rate of substitution between consumption and leisure equal
to the marginal rate of transformation

 The steady-state must satisfy the conditions:

: ss = (gm 1) (m/p)ss
b : 1 + rss = 1/
: 1 + iss = gm/
k : : fk (kss, 1 lss) = 1/ (1 )
um/p (css, gm (m/p)ss , lss)
gm/ 1
m :
=
uc (css, gm (m/p)ss , lss)
gm/
ul (css, gm (m/p)ss , lss)
ss, 1 lss)
n :
=
f
(k
n
uc (css, gm (m/p)ss , lss)
c : css = f (kss, 1 lss) kss
: ss = (gm 1) (m/p)ss

We still get neutrality

But - in general - superneutrality does not hold: gm aects steady state labor
supply, and therefore output, the capital stock and consumption

 Superneutrality requires the marginal rate of substitution between leisure and

consumption be independent of real money balances:
u
u

c, m/p, l

c, m/p, l

u1 (c, l) + u2
or

u1 (c, l) u2

m /p

m /p

Existence and Stability of the Steady-State

Consider the model without leisure again.
Above we derived the conditions for the steady-state - but what are the properties of the steady-state?
Assume that:
u

c, m /p

u1 (c) + u2

m /p

so that the steady-state real balances are determined from:

u2m/p (gm (m/p)ss)

gm/ 1 1 ss
=
uc (c ) 0
gm/
= (gm, css)

 Note that:
lim

m/p0

u2m/p (gm (m/p)) =

and that (gm, css) does not depend on m/p

therefore existence of a steady-state with positive real balances is assured by
for which u1
the condition that there exists some m/p
m/p (gm (m/p)) < 0
but weaker assumptions than this can also be used
for all m/p > m/p

To analyze the dynamics, recall the condition:

u1c (c)

u1c

c (1 + r)

 If = 1/(1 + r) then this implies that consumption is constant and equal to

its steady-state level whatever the nominal interest rate

Next, the money demand equation is:

u2m/p (gmmt/pt)

= 1

u1c (css)

u2m/p (gmmt/pt) mt
u1c (css)

pt

pt
pt+1

mt
mt

pt
pt+1

u2m/p (gmmt/pt) mt
mt+1

= 1
gm pt+1
u1c (css)
pt
This is a non-linear dierence equation
and
ss were considering the stability of
m
t = m
the intersection where p t+1 = m
p
p
t+1

 The left hand side is linear in m/p

We know the following about the right hand side:
lim

m/p0+

2
um/p (gmm/p) m

1
ss
uc (c )
p

where the sign comes from the fact that the square bracket goes to minus
innity as we approach m/p = 0

Consider the special case where:

u1 (c) = ln c
u2 (m/p) = ln m/p

 then the dierence equation reads:

mt+1
mt
=
css
gm pt+1
pt

In this case the dynamics look like:

m/p

10
9
8
7
6
5
4
3
2
1
0
1

-1

Figure 1

10

m/p

 There is a unique steady-state (where the two lines intersect) as long as gm < 1
which requires that gm > which is simply the condition for a positive nominal
interest rate

the steady-state is unstable: to the left we diverge towards negative m/p, to

the right we diverge towards innity

Negative m/p can be ruled out - so to the left, the price level must jump so
that we immediately go to the steady-state

m/p going to innity can be ruled out with the transversality condition - hence,
the price level must jump and we go immediately to the steady state

therefore, the steady-state is unique and saddle-path stable

 More generally, we know only that:

lim

m/p0+

2
um/p (gmm/p) m

u1c (css)
p

if u2m/p,m/p (gmm/p) < 0 we know that the slope must be positive beyond

some m/p
Therefore, the right hand side cuts the left hand side from below at the steadystate and the dynamics look like Figure 2

m/p 7
6
5
4
3
2
1
0
1

m/p

Figure 2

Here there are two steady-states (at the origin and at the positive intersection)
Path that lead to m/p going to innity can still be ruled out with the transversality condition

 But: To the left we converge towards the origin which means that theres
hyperinationary dynamics

This cannot be ruled out in general

Dynamics

Consider the eects of stochastic changes in money supply in a MIU economy

I will consider a parametric example but key results are general and derive also
in CIA economy

We will show that monetary shocks aect the economy through expected
ination

And we will show that these models lack a liquidity eect - nominal interest
rise in response to money supply growth rate shocks

 Preferences are given as:

V0 = E0
lt =
ut =

t=0
1 nt

ac1b
t

tu (ct, mt+1/pt, lt)

+ (1 a) (mt+1/pt
1

(1)/(1b)
1b
)

lt1d
+
1d

This imposes non-separability between consumption and real money balances

When b = = 1 preferences are log-linear in consumption and real money
balances
The production function:

yt = ktn1
t

 Money growth rate process:

where mtn.i.d

ss + g
gmt = (1 ) gm
mt1 + mt

0, 2m

The equilibrium must fulll the following conditions:

:
:
:
:
=
:

yt = ktn1
t
yt = ct + kt (1 ) kt

(1 + rt) = Et [yt+1/kt+1 + (1 )]

1b
1b (1)/(1b)1
act + (1 a) (mt+1/pt)

(1)/(1b)1
b
1b
1b
aEtct+1 act+1 + (1 a) (mt+2/pt+1)
(1 + rt)
(1 nt)d

(1)/(1b)1 = (1 ) yt/nt
1b
1b
acb
ac
+
(1

a)
(m
/p
)
t
t+1
t
t

acb
t

1 a mt+1/pt
a
ct

it
1 + it

p
: (1 + it) = (1 + rt) Et t+1
pt
: mt+1 = gmtmt
gmt
: mt+1/pt =
mt/pt1
pt/pt1
ss + g
: gmt = (1 ) gm
mt1 + mt
which follow from the rst-order conditions derived earlier and imposing the
equilibrium conditions on the budget constraint

Implications

1. Dichotomy: When = b, it follows from above that the real allocation is

independent of monetary shocks

The real variables are determined from:

: yt = ktn1
t
: yt = ct + kt (1 ) kt

: (1 + rt) = Et [yt+1/kt+1 + (1 )]
b
: cb
t = Etct+1 (1 + rt)

(1 nt)d
acb
t

= (1 ) yt/nt

 Ination and real cash balances are then determined jointly by:

1 a mt+1/pt
a
ct

= 1

mt+1/pt =

1
pt+1 1 + rt
pt

gmt
mt/pt1
pt/pt1

Thus, there is classical dichotomy - we can consider the real allocation (apart
from real money balances) and the monetary variables separately.

This is another way of expressing neutrality and superneutrality.

2. Expected Ination: When = b, superneutrality does not hold and money

growth rate shocks aect the economy through expected ination

We have seen the super non-neutrality result before since it follows from the
consumption-leisure choice that now depends on real cash balances:

acb
t

ac1b
t

(1 nt)d

(1)/(1b)1 = (1 ) yt/nt
1b

+ (1 a) (mt+1/pt)

But it is only expected ination that occur from money growth that matters!
Consider the = 0 case where money growth rates are independent over time

 If the ination rate changes one-to-one with the money growth rate shock,
then no other equilibrium conditions are aected:
gmt
mt+1/pt =
mt/pt1
pt/pt1
(1+g

when p /p mt = 1 then real cash balances are independent of gmt

t t1
p

Moreover, Et t+1
pt will not be aected by gmt since the shock is white noise
In other words: Unanticipated money shocks are neutral in this economy

 But when > 0 money shocks matter through its eect on expected ination
p

The equilibrium just described cannot occur since Et t+1

pt will be aected and
this changes the nominal interest rate which in turn aects real cash balances
and consumption etc..

3. The lack of a liquidity eect:

We see that an autocorrelated positive money growth rate shock means that
the current shock increases expected ination - therefore the nominal interest
rate increases! In other words, there is no liquidity eect (negative response
of the nominal interest rate to the money supply)

4. Output, Money and Labor Supply

The output and employment eects of a monetary policy shock depends on

preferences

First note that real money balances fall in response to an increase in the money
growth rate: The nominal interest rate rise - therefore agents hold less real
balances

Recall the labor supply equation:

(1 nt)d nt

(1)/(1b)1 = (1 ) yt
1b

acb
ac1b
+ (1 a) (mt+1/pt)
t
t

 Consider for a moment consumption and output for given and note that the
numerator of the right hand side is increasing in nt
Then if (mt+1/pt) decreases, labor supply increases if
(1 b) [(1 ) / (1 b) 1] < 0

b <
and vice versa if b >
b > implies that the marginal utility of consumption increases with real cash
holdings
Therefore: Money growth shock depresses real money holdings, lowers marginal utility of consumption and increases the demand for leisure (lowers labor
supply)

 The decrease in labor supply the lowers output

In conclusion: Output and labor supply eects can go either way depending
on preferences - however, this is not a general result

In particular: In CIA settings, the sign is always negative - expected ination

lowers the labor supply unambiguously - expected ination lowers real balances
and makes agent want to consume less of all goods

Appendix - Steady-States and CIA

Do the main results above depend crucially on the modeling of a motive for
holding money?

A quick comparison with CIA

We assume that goods markets open before asset markets and write the CIA
constraint as:
ptct mt + Tt

ct mt/pt + t

 The households problem can be formulated as:

V (k, b, m) = max u (c, 1 n) + V

st

c + k

m b
+
+
p
p

k, b, m

f (k, n) + + (1 ) k +
:

(1 + i1) b m
+
p
p

c m/p +

Notice that consumption is a cash good, while investment and leisure are
credit goods

We let denote the multiplier on the budget constraint, and the multiplier
on the CIA constraint which we assume is binding

 The rst-order conditions are:

c : uc (c, 1 n) = +

n : ul (c, 1 n) = fn (k, n)

: Vk

k, b, m

b : Vb k , b , m =
p

m : Vm k , b , m =
p
and the envelope conditions are:

k : Vk (k, b, m) = [fk (k, n) + (1 )]

1 + i1
b : Vb (k, b, m) =
p
1
1
m : Vm (k, b, m) = +
p
p

 Combining them gives us that:

ul (c, 1 n)
= fn (k, n)
uc (c, 1 n)

1+i
1

c, b : [uc (c, 1 n) ] = uc c , n
p
p

c, k : [uc (c, n) ] = uc c , n fk k , n + (1 )

1
1

c, m : [uc (c, n) ] = uc c , n
p
p
c, l :

Notice that: CIA constraint distorts the leisure-consumption choice as in the

model above - hence, money is not superneutral

Had we assumed exogenous labor supply, money would be superneutral as in

the previous model

 It is again straightforward to show that money is neutral

Combine the 2nd and 4th conditions above to get that:

uc

c, n

1+i

= uc

c, n

1
p

i1
=
uc (c, n)
1 + i1

Therefore, as discussed earlier, when the nominal interest rate is positive, the
CIA constraint is binding.