A Classical Monetary Model

Adapted from Jordi Galı́’s slides

Assumptions
• Perfect competition in goods and labor markets (Neither price nor wage setting)
• Flexible prices and wages (MP has no real effects)
• Money held only for transactions
• No capital accumulation (No investment decision by firms)
• No fiscal sector
• Closed economy

Outline
• The problem of households and firms
• Equilibrium: money neutrality and the determination of nominal variables
• A model with money in the utility function
• Optimal policy
Households
Representative household maximizes inter-temporal utility function
X ∞
max E0 β tU (Ct, Nt) (1)
t=0
subject to inter-temporal budget constraint
PtCt + QtBt ≤ Bt−1 + WtNt + Dt (2)
for t = 0, 1, 2, ...and the solvency constraint
lim Et {Λt,T (BT /PT )} ≥ 0 (3)
T →∞

where Λt,T ≡ β T −tUc,T /Uc,t is the stochastic discount factor.

Optimality conditions(Solve by using Lagrange)
Un,t Wt
− = (4)
Uc,t Pt
(Static consumption-leisure choice)
  
Uc,t+1 Pt
Qt = β E t (5)
Uc,t Pt+1

(Derive it from pure intuition about trade-off between current consumption/future con-
sumption: utility gains of current consumption vs. utility gains of future consump-
tion)
Specification of utility:

Ct1−σ −1 Nt1+ϕ

1−σ − 1+ϕ for σ 6= 1
U (Ct, Nt) = Nt1+ϕ
 log Ct − 1+ϕ for σ = 1

implied optimality conditions:

Wt
= Ctσ Ntϕ (6)
Pt
( −σ )
Ct+1 Pt
Qt = βEt (7)
Ct Pt+1
Log-linear versions

wt − pt = σct + ϕnt (8)

1
ct = Et{ct+1} − (it − Et{πt+1} − ρ) (9)
σ
where πt ≡ pt − pt−1, it ≡ − log Qt and ρ ≡ − log β
Steady state (zero growth):
i=π+ρ
implied real rate
r ≡i−π =ρ

Ad-hoc money demand

mt − pt = ct − ηit
Firms
Representative firm with technology
Yt = AtNt1−α (10)
where at ≡ log At follows an exogenous process
at = ρaat−1 + εat

Profit maximization:
max PtYt − WtNt
subject to (10), taking the price and wage as given (perfect competition)

Optimality condition:
Wt
= (1 − α)AtNt−α
Pt

In log-linear terms
wt − pt = at − αnt + log(1 − α)
Equilibrium
Goods market clearing
yt = ct

Labor market clearing

σct + ϕnt = at − αnt + log(1 − α)

Asset market clearing:

Bt = 0
rt ≡ it − Et{πt+1}
= ρ + σEt{∆ct+1}

Aggregate output:
yt = at + (1 − α)nt
Implied equilibrium values for real variables:
nt = ψnaat + ψn
yt = ψyaat + ψy
rt = ρ − σψya(1 − ρa)at
ω t ≡ wt − p t
= at − αnt + log(1 − α)
= ψωaat + ψω

1−σ log(1−α) 1+ϕ

where ψna ≡ σ(1−α)+ϕ+α ; ψn ≡σ(1−α)+ϕ+α ; ψ ya ≡ σ(1−α)+ϕ+α ;
ψy ≡ (1 − α)ψn ; σ+ϕ
ψωa ≡ σ(1−α)+ϕ+α ; ψω ≡ (σ(1−α)+ϕ) log(1−α)
σ(1−α)+ϕ+α

=⇒ neutrality: real variables determined independently of monetary policy

=⇒ optimal policy: undetermined.
=⇒ specification of monetary policy needed to determine nominal variables
Monetary Policy and Price Level Determination
Example I: An Exogenous Path for the Nominal Interest Rate
it = i + vt
where
vt = ρv vt−1 + εvt
Implied steady state inflation: π = i − ρ
Particular case: it = i for all t.
Using definition of real rate:
Et{πt+1} = it − rt
= π + vt − rbt
Equilibrium inflation:
bt = vt−1 − rbt−1 + ξt
π
for any {ξt} sequence with Et{ξt+1} = 0 for all t.
⇒ nominal indeterminacy
Example II: A Simple Interest Rate Rule
it = ρ + π + φπ (πt − π) + vt
where φπ ≥ 0. Combined with definition of real rate:
bt = Et{π
φπ π bt+1} + rbt − vt
If φπ > 1,
∞
X
π
bt = φ−(k+1)
π Et{rbt+k − vt+k }
k=0
σ(1 − ρa)ψya 1
= − at − vt
φπ − ρ a φ π − ρv
If φπ < 1,
π bt−1 − rbt−1 + vt−1 + ξt
bt = φπ π
for any {ξt} sequence with Et{ξt+1} = 0 for all t
=⇒ nominal indeterminacy
=⇒ illustration of the ”Taylor principle” requirement
Responses to a monetary policy shock ( φπ > 1 case):
∂πt 1
v = − <0
∂εt φπ − ρ v
∂it ρv
=− <0
∂εvt φπ − ρ v
∂mt ηρv − 1
= ≶0
∂εvt φπ − ρ v
∂yt
v =0
∂εt
Discussion: liquidity effect and price response.
Example III: An Exogenous Path for the Money Supply {mt}
Combining money demand and the definition of the real rate:
   
η 1
pt = Et{pt+1} + mt + ut
1+η 1+η
where ut ≡ (1 + η)−1(ηrt − yt). Solving forward:
∞  k
1 X η
pt = Et {mt+k } + ut
1 + η k=0 1 + η
P∞  η k
where ut ≡ k=0 1+η Et{ut+k }

⇒ price level determinacy

In terms of money growth rates:
∞  k
X η
pt = mt + Et {∆mt+k } + ut
k=1
1+η
Nominal interest rate:
it = η −1 (yt − (mt − pt))
∞  k
X η
= η −1 Et {∆mt+k } + ut
k=1
1+η
where ut ≡ η −1(ut + yt) is independent of monetary policy.
Example
∆mt = ρm∆mt−1 + εm
t

Assume no real shocks (rt = yt = 0).

Price response:
ηρm
pt = mt + ∆mt
1 + η(1 − ρm)

⇒ large price response

Nominal interest rate response:

ρm
it = ∆mt
1 + η(1 − ρm)

⇒ no liquidity effect
A Model with Money in the Utility Function
Preferences
∞  
X Mt
E0 β tU Ct, , Nt
t=0
Pt
Budget constraint
PtCt + QtBt + Mt ≤ Bt−1 + Mt−1 + WtNt + Dt
with solvency constraint:
lim Et {Λt,T (AT /PT )} ≥ 0
T →∞
where At ≡ Bt + Mt.
Equivalently:
PtCt + QtAt + (1 − Qt)Mt ≤ At−1 + WtNt + Dt

Interpretation: 1 − Qt = 1 − exp{−it} ' it

⇒ opportunity cost of holding money
Optimality Conditions
Un,t Wt
− =
Uc,t Pt
 
Uc,t+1 Pt
Qt = βEt
Uc,t Pt+1
Um,t
= 1 − exp{−it}
Uc,t

Two cases:
• utility separable in real balances ⇒ neutrality
• utility non-separable in real balances ⇒ non-neutrality
Utility specification:
Xt1−σ − 1 Nt1+ϕ
U (Xt, Nt) = −
1−σ 1+ϕ
where
" 1
 1−ν # 1−v
Mt
Xt ≡ (1 − ϑ)Ct1−ν + ϑ f or ν 6= 1
Pt
 ϑ
Mt
≡ Ct1−ϑ f or ν = 1
Pt

Note that
Uc,t = (1 − ϑ)Xtν−σ Ct−ν
Um,t = ϑXtν−σ (Mt/Pt)−ν
Un,t = −Ntϕ
Implied optimality conditions:
Wt
= NtϕXtσ−ν Ctν (1 − ϑ)−1
Pt
( −ν  ν−σ  )
Ct+1 Xt+1 Pt
Qt = βEt
Ct Xt Pt+1
  ν1
Mt 1 ϑ
= Ct (1 − exp{−it})− ν
Pt 1−ϑ

Log-linearized money demand equation:

mt − pt = ct − ηit
where η ≡ 1/[ν(exp{i} − 1)] .
Log-linearized labor supply equation:
wt − pt = σct + ϕnt + (ν − σ)(ct − xt)
= σct + ϕnt + χ(ν − σ) (ct − (mt − pt))
= σct + ϕnt + ηχ(ν − σ)it
1 1− ν1
  ν1
ϑ (1−β)
ν km (1−β) M/P ϑ
where χ ≡ 1 1 1
1− ν
= 1+km (1−β) ∈ [0, 1) with km ≡ C = (1−β)(1−ϑ) .
(1−ϑ) +ϑ (1−β)
ν ν

Equivalently,
wt − pt = σct + ϕnt + $it
km β(1− σν )
where $ ≡ 1+km (1−β)

Discussion
Equilibrium
Labor market clearing:
σct + ϕnt + $it = at − αnt + log(1 − α)
which combined with aggregate production function:
yt = ψyaat + ψyiit
$(1−α) 1+ϕ
where ψyi ≡ − σ(1−α)+ϕ+α and ψya ≡ σ(1−α)+ϕ+α
Assessment of size of non-neutralities
Calibration: β = 0.99 ; σ = 1 ; ϕ = 5 ; α = 1/4 ; ν = 1/ηi ”large”
kmβ km
⇒$' > 0 ; ψyi ' − <0
1 + km(1 − β) 8
Monetary base inverse velocity: km ' 0.3 ⇒ ψyi ' −0.04
M2 inverse velocity: km ' 3 ⇒ ψyi ' −0.4
⇒ small output effects of monetary policy
Response to monetary policy shocks (at = 0)

yt = Θ(mt − pt)
it = −(1/η)(1 − Θ)(mt − pt)
$(1−α)
where Θ ≡ η[σ(1−α)+ϕ+α]+$(1−α) ∈ [0, 1) (assuming $ ≥ 0)
1
yt = Et{yt+1} − (it − Et{πt+1} − $Et{∆it+1} − ρ)
σ
∞  k
η X η + $Λ
pt = mt + Et{∆mt+k }
η + $Λ k=1 1 − Θ + η + $Λ
η(α+ϕ)
where Λ ≡ η[σ(1−α)+ϕ+α]+$(1−α) ∈ [0, 1).
Prediction (independent of rule):
persistent money growth ⇒ cov(∆m, i) > 0 and cov(∆m, y) < 0
Optimal Monetary Policy with Money in the Utility Function

Social Planner’s problem

 
Mt
max U Ct, , Nt
Pt
subject to
Ct = AtNt1−α
Optimality conditions:
Un,t
− = (1 − α)AtNt−α
Uc,t
Um,t = 0

Optimal policy (Friedman rule): it = 0 for all t .

Intuition
Implied average inflation: π = −ρ < 0
Implementation
it = φ(rt−1 + πt)
for some φ > 1. Combined with the definition of the real rate:
Et{it+1} = φit
whose only stationary solution is it = 0 for all t.
Implied equilibrium inflation:
πt = −rt−1