Monetary Economics II: Theory and Policy ECON 3440C: Tasso Adamopoulos York University

Monetary Economics II: Theory and Policy
ECON 3440C
Tasso Adamopoulos
York University
Fall 2021
Lecture 4
ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 1 / 34

1. Recap

Problem of the individual With Money
max U (c1,t , c2,t+1 )

{c1,t ,c2,t+1 }
s.t.
vt
c1,t + · c2,t+1 ≤ y
vt+1
Note: this is not a monetary equilibrium because we do not know the

equilibrium vt+1
vt .

Finding the rate of return
Focus on stationary equilibria: (c1,t , c2,t+1 ) = (c1 , c2 ) for all t.
Individuals form their expectations rationally.

Market Clearing Condition for Fiat Money
Total real money demand for fiat money at t,
Nt (y − c1,t )
Total supply of fiat money in t, measured in goods,
vt Mt
Market clearing condition at t,
vt Mt = Nt (y − c1,t )

Rate of return to fiat money
Value of a dollar at t,
Nt (y − c1,t )
vt =
Mt
Similarly the value of a dollar at t + 1,
Nt+1 (y − c1,t+1 )
vt+1 =
Mt+1
Real rate of return to money at t,

Nt+1 (y −c1,t+1 )
vt+1 Mt+1
= Nt (y −c1,t )
vt
Mt

Stationary equilibrium: c1,t = c1 and c2,t+1 = c2 for all t.
Constant population: Nt = N for all t.
Fixed supply of money: Mt = M for all t.
Real rate of return to money in a stationary equilibrium, with

constant population and fixed money supply,
vt+1
=1
vt

Implications
The value of a dollar, in terms of goods, is constant over time,
vt+1 = vt
The price level is constant over time,
pt+1 = pt

Choice of individual in a stationary monetary equilibrium
Recall the lifetime budget constraint of an individual is in general,
vt
c1,t + · c2,t+1 ≤ y
vt+1
In a stationary monetary equilibrium with a constant population and

fixed money supply the lifetime budget constraint is,
c1 + c2 ≤ y
Graph the constraint and show the optimal consumption choice of an

individual in the stationary monetary equilibrium.
(Be aware that the stationary equilibrium many not be a unique

monetary equilibrium, as there may be more complicated
non-stationary equilibria).
2. Properties of the Stationary
Monetary Equilibrium

Quantity Theory of Money
According to the quantity theory of money the price level is

proportional to the quantity of money in the economy.
Does the quantity theory of money hold in the OLG model?
Recall the value of money in equilibrium is,
Nt (y − c1,t )
vt =
Mt
In a stationary equilibrium with a fixed population and a fixed stock

of fiat money this becomes,
N (y − c1 )
vt =
M

Quantity Theory of Money
1
Since pt = vt the expression for the price level is,
1 M
pt = =
vt N (y − c1 )
This says that the price level is proportional to the stock of fiat
money M.
Suppose there is a once-and-for-all increase in the stock of money,

e.g., from M to 2M (changes once and remains at that level forever
after).
Then the above equation says that the price level would double too,
i.e., from p to 2p.
So the model is consistent with the quantity theory of money.
The Neutrality of Fiat Money
The nominal stock of fiat money M has no effect on real values of

consumption (c1 , c2 ) or the demand for money (y − c1 ) in this
monetary equilibrium.
An increase in M will translate into an increase in p but will not

affect real values.
Budget constraint and preferences do not depend on M, and thus

individual choices of consumption and money balances do not depend
on the total number of dollars, but do depend on the real rate of
return of money vt+1
vt .
vt+1
vt is unaffected by the size of M. Why?
This property of the monetary equilibrium is referred to as the
neutrality of money.

Fiat Money and Welfare
The introduction of fiat money improves welfare in the economy

despite being intrinsically useless, and consumers deriving no direct
utility from it.
Reason: people can trade money for the goods they desire despite the
absence of a double coincidence of wants ⇒ fiat money serves as a
medium of exchange, i.e., it is valued because it helps people get the
goods they want to consume.
If c2 is a market good and c1 is a non-market good, we can say that

fiat money provides a means for individuals to purchase market goods.

Is the monetary equilibrium the Golden Rule?
Fiat money improves welfare, but are individuals just better off or as
well off as possible? Does the monetary equilibrium result in the best
possible allocation for the economy (Golden Rule)?
Budget line from the individual problem in a stationary monetary
equilibrium,
c1 + c2 ≤ y
Feasible set line of the central planner’s problem under a stationary

allocation,
c1 + c2 ≤ y
Identical! Given that preferences, represented by indifference curves

are also the same, the individual’s consumption choice in the SME is
identical to the planner’s choice (c1∗ , c2∗ ), i.e., the SME attains the
Golden Rule.
What about the initial old?
The initial old are also better off in the SME than in the autarkic
equilibrium.
In the SME they receive,

v1 M
v1 m0 =
N
units of the consumption good, when they trade their initial money
holdings for goods with the young in period 1.
So they will have positive consumption, which is better than zero that
they would get in the autarkic equilibrium.

3. A Monetary Equilibrium with
a Growing Economy

Motivation
In the basic OLG model a constant value of money implied that the
stationary monetary equilibrium obeyed the Golden Rule.
What if the value of money changes over time? Are there cases in
which a changing value of money maximizes the utility of future
generations?
First we will consider changes in the value of money coming from

changes in the demand for fiat money.
To get a growing demand for fiat money you need the total amount
of consumption goods Nt · y to grow over time.
There are two ways to get total goods Nt · y to grow,

I population growth Nt
I endowment growth y

Population growth
Consider here the case of population growth.
Assume that the population grows (exogenously) at the (net) rate

n − 1, such that the population in t is,
Nt = nNt−1
n = gross rate of population growth
Nt = number of people in the economy in period t
Nt−1 = number of people in the economy in period t − 1

Feasible Set in a Growing Economy
Nt y = total number of goods available for allocation in period t.
Assume every individual within a generation receives identical

consumption.
Nt c1,t = aggregate consumption of the young in period t.
Nt−1 c2,t = aggregate consumption of the old in period t.

Feasibility Constraint of the Planner
Nt c1,t + Nt−1 c2,t ≤ Nt y
Consider here the set of stationary allocations: c1,t = c1 and

c2,t = c2 .
And divide through by Nt to obtain the stationary per capita

feasibility constraint.
Nt−1
c1,t + c2,t ≤ y
Nt
or
1
c1 + c2 ≤ y
n

Feasibility constraint
Graph
if c o D
Cz n
y vertical
intercept
if Cz O cc Y horizontal
intercept
Cz T
ny
Feasibility line
y inageqg.y.gg
X
y
hi
With n
Young For each old
a
growing pop
IF you divide the entire endowment
of the current the
young among
current old each gels
Nt 4
Tree n Y goods
Problem of the Planner
Find the allocation (among stationary allocations) that maximizes the

utility of future generations U (c1 , c2 ) subject to the stationary per
capita feasibility constraint,
1
c1 + c2 ≤ y
n
The optimal allocation from the planner’s problem is called the

Golden Rule Allocation: (c1∗ , c2∗ ).
Graphically it occurs where the highest possible indifference curve is

tangent to the feasibility constraint.

Golden Rule Allocation
I
Can point It
co co
c
Individual Budget Constraints with Money
Budget constraint in first period of life (real),
c1,t + vt · mt ≤ y
Budget constraint in second period of life (real),
c2,t+1 ≤ vt+1 · mt
Lifetime budget constraint (real),

vt
c1,t + · c2,t+1 ≤ y
vt+1

Market Clearing
real supply of money = real demand for money


Deriving the rate of return
The value of a unit of fiat money in t,
Nt (y − c1,t )
vt =
Mt
similarly the value of a dollar in t + 1 is given by,

Nt+1 (y − c1,t+1 )
vt+1 =
Mt+1
Using the equations for vt and vt+1 we can compute the real rate of
return to money as,
Nt+1 (y −c1,t+1 )
vt+1 Mt+1
= Nt (y −c1,t )
vt
Mt

Using the assumptions of stationary equilibrium and constant supply

of money,
vt+1 Nt+1
= =n>1
vt Nt
The rate of return to money is constant and equal to the growth rate
of the economy (population growth rate).
Note: the case with a constant population is a special case of this with
n = 1.

Value of Money
The value of money,

vt+1 = nvt
Since n > 1 the value of money is increasing over time.
Intuition: a higher real demand for fiat money over time will raise its
value over time.
With the same money you can buy more goods.
Reason: same dollars but more and more people demanding them.

Prices
Given that pt = 1/vt

1
pt+1 = pt
n
Goods are cheaper because they are relatively more abundant.

Individual budget constraint in a SME
Individual lifetime budget constraint (in general),

vt
c1,t + · c2,t+1 ≤ y
vt+1
Using the assumptions of stationary equilibrium and the derived rate

of return to money,
1
c1 + c2 ≤ y
n

Comparison to Golden Rule
What do you notice?
The budget constraint that individuals face is a stationary monetary

equilibrium is identical to the feasibility constraint.
Since preferences are also the same, the optimal choice of an

individual on the budget line coincides with the Golden Rule, i.e., the
best allocation feasible for future generations.
A benevolent planner can do not better than individuals acting within

their budget sets.
Note: the same applies with a shrinking population, n < 1.

4. A Monetary Equilibrium with
a Growing Money Supply

Big Picture
So far we focused on factors that affected the demand for fiat money.
Here we focus on the supply of fiat money.
Questions:
I What are the consequences of an increasing stock of fiat money?
I What effect does such a policy have on the welfare of individuals in the
economy?
I Can a government raise revenue just by printing money at a faster rate?

Growing Supply of Fiat Money
Constant population, Nt = N for all t.
Money supply grows at the constant (exogenous) rate z > 1 each

period t,
Mt = zMt−1
z = gross rate of money supply expansion.
Implication: the newly printed dollars are given by,

Mt 1
Mt − Mt−1 = Mt − = 1− Mt
z z

Government Budget Constraint
New money is introduced into the economy as lump-sum subsidies

(transfers) to each old person in every period t.
I Lump-sum: does not depend on any action taken by the individual.
at = money transfer to each old person in terms of the consumption

good at time t.
Government budget constraint at time t,

1
Nt−1 at = 1 − Mt vt
z
Real subsidy per old person in t,
1 − z1 Mt vt

at =
Nt−1

Lump-sum?
The amount of the subsidy given to each old does not depend on any
decision they make.
By returning the newly printed money to the public we can study the
effects of the expansion of the money supply in isolation from the
transfer of resources from the public to the government.

Individual Budget Constraints
Budget constraint in first period of life (real),
c1,t + vt · mt ≤ y
Budget constraint in second period of life (real),
c2,t+1 ≤ vt+1 · mt + at+1
Lifetime budget constraint (real),

vt vt
c1,t + · c2,t+1 ≤ y + · at+1
vt+1 vt+1

Market Clearing
real supply of money = real demand for money


Deriving the rate of return
The value of a unit of fiat money in t,
Nt (y − c1,t )
vt =
Mt
similarly the value of a dollar in t + 1 is given by,

Nt+1 (y − c1,t+1 )
vt+1 =
Mt+1
Using the equations for vt and vt+1 we can compute the real rate of
return to money as,
Nt+1 (y −c1,t+1 )
vt+1 Mt+1
= Nt (y −c1,t )
vt
Mt

Using the assumptions of stationary equilibrium (c1,t = c1 ) and

constant population (Nt = N),
vt+1 Mt 1
= = <1
vt Mt+1 z
The rate of return to money is constant and equal to the inverse of

the gross rate of fiat money expansion.
Implication: Further, the higher z the lower the rate of return to money.

Value of Money
The value of money,

1
vt+1 =
vt
z
With z > 1 the value of money declines over time.
Intuition: for a given real demand for fiat money the higher the
supply the lower its value over time.
With the same money you can buy fewer goods.
Reason: more and more dollars bid for the same amount of goods.

Prices
Given that pt = 1/vt

pt+1 = zpt
Inflation! Prices of goods increase over time in terms of dollars.
Does the quantity theory of money still hold? What happens to M/p?

The budget set with monetary growth
Individual lifetime budget constraint,

vt vt
c1,t + · c2,t+1 ≤ y + · at+1
vt+1 vt+1
Using the assumptions of stationary equilibrium (including that at = a

for all t) and the derived rate of return to money,
c1 + zc2 ≤ y + za

Graph individual budget constrain
if C o Cz toe vertical
intercept
if Cz o D C Yt Z OC horizontal
intercept
2x
tµ
a c
Yt't
Monetary equilibrium with monetary growth
Stationary monetary equilibrium: occurs where the highest possible

indifference curve is tangent to the lifetime budget constraint, c1∗ , c2∗ .
Inflation z > 1 has altered the budget set in two ways:

1 The budget line is flatter: to get 1 unit of goods when old, an
individual must give up more units when young than with inflation.
F Reason: inflation erodes the value of money → with the same dollars
you can buy fewer goods now because they are more expensive.
2 The budget set intercepts the horizontal axis at y + za rather than y .
F Reason: in principle people can consume more than y by borrowing
against their future subsidy (in practice this will not happen as no one
is willing to lend).

with Growth
Monetary Equilibrium
of Money Supply
to
I
4 e
µ.is
E.sn.um
I
l Oo
I i
I f
i
1 I
c
y Yt't a 9
real demand
For money
Implications of the monetary equilibrium
Common sense would suggest that a government without goods can

provide subsidies only by taking goods from private citizens, i.e.,
through taxation.
Yet, money creation seems like a way to raise revenue without

taxation. Is this really so?
The real value of the subsidy must come from somewhere.
The feasible set is not expanded just because the government prints
money: the total number of goods remain fixed at Nt y .

Implications of the monetary equilibrium
The gifts to the old can come only from losses sustained by them or
others.
When the stock of fiat money increases the value of money currently
held by citizens falls in value.
The new money competes with the old money to buy the (same)
goods of the young → this drives up the price of these goods.
The losses are sustained by the holders of the old money → works as
a tax on money holdings.
The value lost to the “inflation tax” is proportional to the amount of

money held.
To reduce exposure to this tax, people will choose to hold less money.

3. Efficiency of Equilibrium with
Growing Money Supply

Efficiency question
Is the expansion of the money stock optimal?

Does it make sense from a welfare perspective?
Is inflation efficient?
Compare budget set to feasible set,

I budget set: shows options available to an individual in a monetary
equilibrium
I feasible set: consumption allocations feasible for the economy
If the budget set coincides with the feasible set then the Golden Rule
allocation is attainable under the monetary equilibrium.

Feasible Set
The government’s expansion of fiat money does not have an effect on

what is feasible in this economy.
Printing money does not alter the amount of goods Nt y available for
distribution between the young and old.
The feasible set is exactly the same as in the basic OLG model,
Nt c1,t + Nt−1 c2,t ≤ Nt y

Feasibility Constraint
Stationary allocation for each generation t,

(
c1,t = c1
c2,t = c2
Constant population Nt = N for all t.
Stationary per capita feasibility constraint,
c1 + c2 ≤ y

Comparison of SME and GRA
To compare the stationary monetary equilibrium (SME) and the

Golden Rule Allocation (GRA) put them on the same graph.
The feasible set line intersects the budget line at the SME (c1∗ , c2∗ ).
If (c1∗ , c2∗ ) was in the interior of the feasible set it would mean that we
are throwing away goods → not consistent with utility maximization.
If (c1∗ , c2∗ ) was outside the feasible set, it would mean that people are
consuming more goods than exist → impossible.
Therefor the equilibrium consumption bundle (c1∗ , c2∗ ) must lie on the
edge of the feasible set, i.e., the feasible set line must pass through
(c1∗ , c2∗ ).

Now, because (c1∗ , c2∗ ) represents the highest possible utility affordable
to the individual, the consumption bundle (c1∗ , c2∗ ) is located where
the highest possible indifference curve U 0 is tangent to the budget
line.
The absolute slope of the budget line is z1 .
The absolute slope of the feasible set line is 1.

1
Since z < 1 the budget line is flatter than the feasible set line.
Given that the feasible set line is going through (c1∗ , c2∗ ) but at a
different slope it cannot also be tangent to indifference curve U 0 but
must intersect it.
This means that in the feasible set there are points of higher utility
for future generations that the SME (c1∗ , c2∗ ).
For example, point A on indifference curve U 1 is preferred by future
generations because it lies on a higher indifference curve.
Furthermore, because it offers more c2 than the SME (c1∗ , c2∗ ), it is

also preferred by the initial old over the SME.
Since future generations preferred point A why didn’t they choose it?
Reason: they could not afford it! Point A is not in their budget set.
The rate of return to money is too low for future generations to be

able to consume at point A.
If individuals were to consume c1A their money holdings would be too

small to afford c2A .
Given the policy of monetary expansion the SME is the best

individuals could do.
OLG model with fixed money supply:

I no expansion of money: z = 1
I no transfers to old: a = 0
There the budget line was identical to the feasible set line.
Future generations were able to choose A that maximized their utility.
Future generations prefer the SME without an expanding money

supply.

Welfare Cost of Inflation
Inflation caused by money expansion does not destroy goods:

individuals still consume on the edge of the feasible set.
But, they consume a different combination of (c1 , c2 ) with inflation

than without it.
I they choose to consume less of c2 (market good for which they need to
use money) and more of c1 (the endowment good), because of money’s
low rate of return.
The inflation tax, induces future generations to reduce their real

demand for money (y − c1 ) to a level below the optimum.
The resulting drop in money demand reduces the value of the initial
money holdings of the initial old, reducing their utility too.

Cost of Inflation
People are induced by fiat money’s low rate of return to consume

needlessly less of goods that require the use of money (like c2 ) in favour of
those that do not (like c1 ).

Generally
Inflation causes people to economize needlessly on the benefits offered

by the use of money to conduct transactions: inflation will reduce
welfare whenever money offers benefits to those who use it and
people face a non-trivial choice of how much money to hold.
The larger z, i.e., the flatter the budget line, the worse off individuals
are because the farther away they are from the Golden Rule.

Monetary Economics II: Theory and Policy ECON 3440C: Tasso Adamopoulos York University

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Monetary Economics II: Theory and Policy ECON 3440C: Tasso Adamopoulos York University

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Monetary Economics II: Theory and Policy

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 1 / 34

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 2 / 34

max U (c1,t , c2,t+1 )

Note: this is not a monetary equilibrium because we do not know the

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 3 / 34

Focus on stationary equilibria: (c1,t , c2,t+1 ) = (c1 , c2 ) for all t.

Individuals form their expectations rationally.

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 4 / 34

Total real money demand for fiat money at t,

Total supply of fiat money in t, measured in goods,

Market clearing condition at t,

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 5 / 34

Real rate of return to money at t,

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 6 / 34

Stationary equilibrium: c1,t = c1 and c2,t+1 = c2 for all t.

Constant population: Nt = N for all t.

Fixed supply of money: Mt = M for all t.

Real rate of return to money in a stationary equilibrium, with

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 7 / 34

The value of a dollar, in terms of goods, is constant over time,

The price level is constant over time,

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 8 / 34

In a stationary monetary equilibrium with a constant population and

Graph the constraint and show the optimal consumption choice of an

(Be aware that the stationary equilibrium many not be a unique

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 10 / 34

According to the quantity theory of money the price level is

Does the quantity theory of money hold in the OLG model?

Recall the value of money in equilibrium is,

In a stationary equilibrium with a fixed population and a fixed stock

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 11 / 34

Suppose there is a once-and-for-all increase in the stock of money,

The nominal stock of fiat money M has no effect on real values of

An increase in M will translate into an increase in p but will not

Budget constraint and preferences do not depend on M, and thus

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 13 / 34

The introduction of fiat money improves welfare in the economy

If c2 is a market good and c1 is a non-market good, we can say that

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 14 / 34

Feasible set line of the central planner’s problem under a stationary

Identical! Given that preferences, represented by indifference curves

In the SME they receive,

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 16 / 34

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 17 / 34

First we will consider changes in the value of money coming from

There are two ways to get total goods Nt · y to grow,

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 18 / 34

Consider here the case of population growth.

Assume that the population grows (exogenously) at the (net) rate

n = gross rate of population growth

Nt = number of people in the economy in period t

Nt−1 = number of people in the economy in period t − 1

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 19 / 34

Nt y = total number of goods available for allocation in period t.

Assume every individual within a generation receives identical

Nt c1,t = aggregate consumption of the young in period t.

Nt−1 c2,t = aggregate consumption of the old in period t.

ECON3440C - Adamopoulos Monetary Economics, Lecture 4 2021 20 / 34