A Classical Monetary Model
Jordi Galí
October 2015
Assumptions
Perfect competition in goods and labor markets
Flexible prices and wages
No capital accumulation
No …scal sector
Closed economy
Outline
The problem of households and …rms
Equilibrium: money neutrality and the determination of nominal variables
A model with money in the utility function
Optimal policy
Households
Representative household solves
1
X
t
max E0 U (Ct; Nt) (1)
t=0
subject to
PtCt + QtBt Bt 1 + WtNt + Dt (2)
for t = 0; 1; 2; :::and the solvency constraint
lim Et f t;T (BT =PT )g 0 (3)
T !1
T t
where t;T Uc;T =Uc;t is the stochastic discount factor.
Optimality conditions
Un;t Wt
= (4)
Uc;t Pt
Uc;t+1 Pt
Qt = Et (5)
Uc;t Pt+1
Speci…cation of utility:
(
Ct1 1 Nt1+'
1 1+' for 6= 1
U (Ct; Nt) = Nt1+'
log Ct 1+' for =1
implied optimality conditions:
Wt
= Ct Nt' (6)
Pt
( )
Ct+1 Pt
Q t = Et (7)
Ct Pt+1
Log-linear versions
wt pt = ct + 'nt (8)
1
ct = Etfct+1g (it Etf t+1 g ) (9)
where t pt p t 1 , it log Qt and log
Steady state (zero growth):
i= +
implied real rate
r i =
Ad-hoc money demand
mt pt = ct it
Firms
Representative …rm with technology
Yt = AtNt1 (10)
where at log At follows an exogenous process
at = aat 1 + "at
Pro…t maximization:
max PtYt WtNt
subject to (10), taking the price and wage as given (perfect competition)
Optimality condition:
Wt
= (1 )AtNt
Pt
In log-linear terms
wt pt = at nt + log(1 )
Equilibrium
Goods market clearing
yt = ct
Labor market clearing
ct + 'nt = at nt + log(1 )
Asset market clearing:
Bt = 0
rt it Etf t+1g
= + Etf ct+1g
Aggregate output:
yt = at + (1 )nt
Implied equilibrium values for real variables:
nt = na at + n
yt = ya at + y
rt = ya (1 a )at
!t wt pt
= at nt + log(1 )
= !aat + !
1 log(1 ) 1+'
where na (1 )+'+ ; n (1 )+'+ ; ya (1 )+'+ ;
+' ( (1 )+') log(1 )
y (1 ) n ; !a (1 )+'+ ; ! (1 )+'+
=) neutrality: real variables determined independently of monetary policy
=) optimal policy: undetermined.
=) speci…cation 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 + v t
where
vt = v vt 1 + "vt
Implied steady state in‡ation: = i
Particular case: it = i for all t.
Using de…nition of real rate:
Etf t+1 g = it r t
= + vt rbt
Equilibrium in‡ation:
bt = vt 1 rbt 1 + t
for any f tg sequence with Etf t+1g = 0 for all t.
) nominal indeterminacy
Example II: A Simple Interest Rate Rule
it = + + ( t ) + vt
where 0. Combined with de…nition of real rate:
bt = Etfbt+1g + rbt vt
If > 1,
1
X
(k+1)
bt = Etfb
rt+k vt+k g
k=0
(1 a ) ya 1
= at vt
a v
If < 1,
bt = bt 1 rbt 1 + vt 1 + t
for any f tg sequence with Etf t+1g = 0 for all t
=) nominal indeterminacy
=) illustration of the "Taylor principle" requirement
Responses to a monetary policy shock ( > 1 case):
@ t 1
v = <0
@"t v
@it v
v = <0
@"t v
@mt 1
= v
70
@"vt v
@yt
v =0
@"t
Discussion: liquidity e¤ect and price response.
Example III: An Exogenous Path for the Money Supply fmtg
Combining money demand and the de…nition of the real rate:
1
pt = Etfpt+1g + m t + ut
1+ 1+
where ut (1 + ) 1( rt yt). Solving forward:
1
1 X
k
pt = Et fmt+k g + ut
1+ 1+
k=0
P1 k
where ut k=0 1+ Etfut+k g
) price level determinacy
In terms of money growth rates:
1
X k
pt = mt + Et f mt+k g + ut
1+
k=1
Nominal interest rate:
1
it = (yt (mt pt))
X1 k
1
= Et f mt+k g + ut
1+
k=1
1
where ut (ut + yt) is independent of monetary policy.
Example
mt = m mt 1 + "m
t
Assume no real shocks (rt = yt = 0).
Price response:
m
pt = mt + mt
1 + (1 m)
) large price response
Nominal interest rate response:
m
it = mt
1 + (1 m)
) no liquidity e¤ect
A Model with Money in the Utility Function
Preferences
1
X
t Mt
E0 U Ct; ; Nt
t=0
Pt
Budget constraint
PtCt + QtBt + Mt Bt 1 + Mt 1 + WtNt + Dt
with solvency constraint:
lim Et f t;T (AT =PT )g 0
T !1
where At Bt + Mt.
Equivalently:
PtCt + QtAt + (1 Qt)Mt At 1 + WtNt + Dt
Interpretation: 1 Qt = 1 expf itg ' it
) opportunity cost of holding money
Optimality Conditions
Un;t Wt
=
Uc;t Pt
Uc;t+1 Pt
Q t = Et
Uc;t Pt+1
Um;t
= 1 expf itg
Uc;t
Two cases:
utility separable in real balances ) neutrality
utility non-separable in real balances ) non-neutrality
Utility speci…cation:
Xt1 1 Nt1+'
U (Xt; Nt) =
1 1+'
where
" #11v
1
Mt
Xt (1 #)Ct1 +# f or 6= 1
Pt
#
Mt
Ct1 #
f or =1
Pt
Note that
Uc;t = (1 #)Xt Ct
Um;t = #Xt (Mt=Pt)
Un;t = Nt'
Implied optimality conditions:
Wt
= Nt'Xt Ct (1 #) 1
Pt
( )
Ct+1 Xt+1 Pt
Q t = Et
Ct Xt Pt+1
1
Mt 1 #
= Ct (1 expf itg)
Pt 1 #
Log-linearized money demand equation:
mt pt = ct it
where 1=[ (expfig 1)] .
Log-linearized labor supply equation:
wt pt = ct + 'nt + ( )(ct xt)
= ct + 'nt + ( ) (ct (mt pt))
= ct + 'nt + ( )it
1 1
1 1
# (1 ) km (1 ) M=P #
where 1 1 1 = 1+km (1 ) 2 [0; 1) with km C = (1 )(1 #) :
(1 #) +# (1 )1
Equivalently,
wt pt = ct + 'nt + $it
km (1 )
where $ 1+km (1 )
Discussion
Equilibrium
Labor market clearing:
ct + 'nt + $it = at nt + log(1 )
which combined with aggregate production function:
yt = ya at + yi it
$(1 ) 1+'
where yi (1 )+'+ and ya (1 )+'+
Assessment of size of non-neutralities
Calibration: = 0:99 ; = 1 ; ' = 5 ; = 1=4 ; = 1= i "large"
km km
)$' >0 ; yi ' <0
1 + km(1 ) 8
Monetary base inverse velocity: km ' 0:3 ) yi ' 0:04
M2 inverse velocity: km ' 3 ) yi ' 0:4
) small output e¤ects of monetary policy
Response to monetary policy shocks (at = 0)
yt = (mt pt)
it = (1= )(1 )(mt pt )
$(1 )
where [ (1 )+'+ ]+$(1 ) 2 [0; 1) (assuming $ 0)
1
yt = Etfyt+1g (it Etf t+1 g $Etf it+1g )
1
X k
+$
pt = mt + Etf mt+k g
+$ 1 + +$
k=1
( +')
where [ (1 )+'+ ]+$(1 ) 2 [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
Optimality conditions:
Un;t
= (1 )AtNt
Uc;t
Um;t = 0
Optimal policy (Friedman rule): it = 0 for all t .
Intuition
Implied average in‡ation: = <0
Implementation
it = (rt 1 + t)
for some > 1. Combined with the de…nition of the real rate:
Etfit+1g = it
whose only stationary solution is it = 0 for all t.
Implied equilibrium in‡ation:
t = rt 1
