Sharif University of Technology
Graduate School of Management and Economics
Monetary Neutrality
Lucas (1996)
Navid Raeesi
Fall 2013
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Chapter 9: Regression with Time Series Data:
Monetary Neutrality
Stationary Variables
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What are we going to see?
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Chapter 9: Regression with Time Series Data:
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Stationary Variables
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Inflation and broad money growth
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Chapter 9: Regression with Time Series Data:
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Inflation and broad money growth
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Chapter 9: Regression with Time Series Data:
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Money and Prices During Four Big Inflation
Source: Sargent (1981)
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Chapter 9: Regression with Time Series Data:
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Average Money Growth and Inflation (1960-90)
Source: McCandless and Weber (1995)
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Chapter 9: Regression with Time Series Data:
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Average money growth and growth in real output (1960-90)
Source: McCandless and Weber (1995)
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Stationary Variables
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Inflation and unemployment in the United states
Source: Friedman and Schawrtz (1963)
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Chapter 9: Regression with Time Series Data:
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Introduction
 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.
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Chapter 9: Regression with Time Series Data:
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Stationary Variables
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Introduction
 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”?
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Chapter 9: Regression with Time Series Data:
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Developments of monetary economics since 1960s till today
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Stationary Variables
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A basic real business cycle (RBC) model
 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
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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.
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Chapter 9: Regression with Time Series Data:
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Stationary Variables
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Incorporating money
 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).
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Chapter 9: Regression with Time Series Data:
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Stationary Variables
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A Simple General Equilibrium Framework
 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.
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A Simple General Equilibrium Framework
 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 uselessand hence keep the value of tokens in terms of goods at any level
above zero?
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A Simple General Equilibrium Framework
 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.
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Chapter 9: Regression with Time Series Data:
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A Simple General Equilibrium Framework
 What if we consider monetary changes that differ from once-and-forall 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
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A Simple General Equilibrium Framework
 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
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Chapter 9: Regression with Time Series Data:
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A Simple General Equilibrium Framework
 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.
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Chapter 9: Regression with Time Series Data:
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Stationary Variables
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A Simple General Equilibrium Framework
 Other models that offer rationalization of a short-run monetary nonneutrality 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 nonneutrality 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?
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Chapter 9: Regression with Time Series Data:
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Conclusion
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Thanks for Your Attention!
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Stationary Variables
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