EC3115 Vle

Monetary economics
Y. Aksoy
EC3115
2015
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 6 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr Y. Aksoy, Reader in Economics, Department of Economics, Mathematics and Statistics,
Birkbeck, University of London.
Some of the material in this subject guide has been adapted from the previous edition,
written by:
Ryan Love, formerly of the London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
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Contents
Contents
1 Introduction to the subject guide 7

1.1 The structure of the guide . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2 The subject guide and the syllabus . . . . . . . . . . . . . . . . . . . . . 7
1.3 Specifics of the syllabus . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.4 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.5 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.6 Subject chapters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.7 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.8 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.9 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.10 Online study resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.11 How to use this subject guide . . . . . . . . . . . . . . . . . . . . . . . . 14
1.12 The examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1.13 Use of mathematics and statistics . . . . . . . . . . . . . . . . . . . . . . 16
2 The nature of money 17

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.7 What is money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.8 The functions of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.9 Why do we have money? . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.10 Types of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.11 Properties of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.12 A reminder of your learning outcomes . . . . . . . . . . . . . . . . . . . . 26
2.13 Sample examination questions . . . . . . . . . . . . . . . . . . . . . . . . 27
2.14 Feedback to Sample examination questions . . . . . . . . . . . . . . . . . 27
1
Contents
3 The demand for money 29

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.7 Microeconomic determinants of the demand for money . . . . . . . . . . 31
3.8 Baumol–Tobin transactions demand for money . . . . . . . . . . . . . . . 33
3.9 Tobin’s model of portfolio selection . . . . . . . . . . . . . . . . . . . . . 35
3.10 Macroeconomic determinants of money demand . . . . . . . . . . . . . . 36
3.11 The stability of the money demand function . . . . . . . . . . . . . . . . 38
3.12 Reasons for the breakdown of the money demand functions . . . . . . . . 39
3.15 Feedback to Activity 3.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
4 The supply of money 43

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
4.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
4.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.7 Financial intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
4.8 The money multiplier and base money . . . . . . . . . . . . . . . . . . . 46
4.9 A simple model of the banking sector . . . . . . . . . . . . . . . . . . . . 47
5 Classical theory 57
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
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Contents

5.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
5.7 The quantity theory of money . . . . . . . . . . . . . . . . . . . . . . . . 58
5.8 A simple general equilibrium framework . . . . . . . . . . . . . . . . . . 63
6 Stylised facts 69
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
6.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
6.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
6.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
6.7 Trends and business cycles . . . . . . . . . . . . . . . . . . . . . . . . . . 71
6.8 Moments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
6.9 Cross country business cycle evidence . . . . . . . . . . . . . . . . . . . . 78
6.10 Key macroeconomic relationships . . . . . . . . . . . . . . . . . . . . . . 79
6.10.1 Relationship between monetary aggregates and inflation . . . . . 79
6.11 Relationship between monetary instruments and macroeconomy . . . . . 80
6.12 Price level stickiness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
7 Money, inflation and welfare 85

7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
7.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
7.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
7.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
7.7 Inflation as taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
3
Contents

8 Classical models and monetary policy 101

8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
8.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
8.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
8.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
8.7 The classical model revisited . . . . . . . . . . . . . . . . . . . . . . . . . 103
8.8 The effect of monetary policy . . . . . . . . . . . . . . . . . . . . . . . . 103
8.9 Real business cycle theory . . . . . . . . . . . . . . . . . . . . . . . . . . 106
8.10 Business cycle facts and RBC theory . . . . . . . . . . . . . . . . . . . . 106
8.11 Classical models with real effects of money . . . . . . . . . . . . . . . . . 107
8.15 Appendix to Chapter 8: a ‘simple’ RBC model . . . . . . . . . . . . . . . 111
9 Keynesian models with money supply as a policy instrument 119

9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
9.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
9.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
9.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
9.7 Keynesian aggregate supply function . . . . . . . . . . . . . . . . . . . . 121
9.8 Predictable and unpredictable components of the money supply . . . . . 130
10 New Keynesian models of monetary policy 137

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
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Contents
10.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

10.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
10.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
10.7 IS-PC-MR model of new Keynesian economics . . . . . . . . . . . . . . . 139
10.8 Analysing demand shocks . . . . . . . . . . . . . . . . . . . . . . . . . . 141
10.9 Analysing supply shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
10.10 Financial accelerator models . . . . . . . . . . . . . . . . . . . . . . . . 145
10.11 Simple monetary policy rules . . . . . . . . . . . . . . . . . . . . . . . . 147
10.12 A reminder of your learning outcomes . . . . . . . . . . . . . . . . . . . 149
10.13 Sample examination questions . . . . . . . . . . . . . . . . . . . . . . . 150
10.14 Feedback to Sample examination questions . . . . . . . . . . . . . . . . 150
11 Time inconsistency and inflation bias 151

11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
11.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
11.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
11.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
11.7 Time inconsistency and inflation bias . . . . . . . . . . . . . . . . . . . . 153
11.8 Inflation aversion, steepness of the Phillips curve and interest rates . . . 155
11.9 Ways inflation bias can be reduced . . . . . . . . . . . . . . . . . . . . . 156
11.9.1 Delegation of monetary policy to a conservative central bank: central
bank independence . . . . . . . . . . . . . . . . . . . . . . . . . . 156
11.9.2 Inflation contract for the central bank . . . . . . . . . . . . . . . . 156
11.9.3 Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
12 Monetary policy and data/parameter uncertainties 161

12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
12.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
12.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
5
Contents

12.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
12.7 Data uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
12.8 Parameter (or multiplicative) uncertainty . . . . . . . . . . . . . . . . . . 165
12.8.1 The New Keynesian model and parameter uncertainty . . . . . . 167
12.8.2 Graphical exposition . . . . . . . . . . . . . . . . . . . . . . . . . 170
12.9 Interest rate smoothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
13 The term structure of interest rates 175

13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
13.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
13.4 Reading advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
13.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
13.7 The yield curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
13.8 Why is the yield curve of importance to policy-makers? . . . . . . . . . . 177
13.9 Bond prices and the rate of return . . . . . . . . . . . . . . . . . . . . . . 178
13.10 Empirical regularities of the term structure . . . . . . . . . . . . . . . . 179
13.11 The expectations hypothesis . . . . . . . . . . . . . . . . . . . . . . . . 179
13.12 The segmentation hypothesis . . . . . . . . . . . . . . . . . . . . . . . . 180
13.13 Preferred habitat theory . . . . . . . . . . . . . . . . . . . . . . . . . . 181
A Sample examination paper 185
B Examiners’ commentary to Sample examination paper 189
6
Chapter 1
Introduction to the subject guide
1.1 The structure of the guide

The subject guide broadly mirrors the syllabus, which is split into three sections.
The first section of the guide (Chapters 2–5) introduces the concept of money;
what it is, why we use it and how it is created. The role of banks and the banking
sector will be analysed in this section only, leaving the rest of the guide to focus on
policy issues.
The second section (Chapters 6–10) examines monetary policy in a closed economy,
considering a number of models that allow real effects of monetary policy, ranging
from new-Classical to new-Keynesian. Specific models will be introduced and
solved, allowing you to see exactly how these models work and what differentiates
one from another.
The third section of the guide considers important issues in the design of monetary
policymaking. Topics include i) time inconsistency in monetary policy design, ii)
monetary policy in an uncertain environment such as data and parameter
uncertainties that monetary policy makers face and how policy makers can
alleviate problems associated with these uncertainties and iii) term structure of
interest rates.
Please see the syllabus at the end of this ‘Introduction’.
1.2 The subject guide and the syllabus

The aim of the guide is to enable you to interpret fully the published syllabus for the
EC3115 Monetary economics course. It does so by identifying what you are
expected to know within each area of the syllabus, and suggesting the reading that will
be most helpful in acquiring an understanding of the material concerned. It cannot be
emphasised strongly enough that the guide is not a substitute for reading textbooks and
other references.
1.3 Specifics of the syllabus

Important: the information given in the following section is based on the syllabus at
the time this guide was written. However, you should refer to the Programme handbook
for the latest version of the syllabus and any additional information.
7
1. Introduction to the subject guide
Section 1: Introduction to money and monetary economics
The nature of money:
What constitutes money. Why people hold money; introduction to cash in advance
(CIA) and money in the utility (MIU) functions.
Money demand and supply:
Microeconomic determinants of the demand for money and macroeconomic money

demand functions. Financial intermediaries, banks and money creation.
The Classical school, neutrality of money and the quantity theory:
The Classical dichotomy, Walras’ and Say’s laws, introduction to money in a

general equilibrium setting.
Section 2: Monetary policy
Stylised facts and monetary policy:
Trends and business cycles. Means, volatility, cyclicality and persistence in

macroeconomic time series. Money and macroeconomic variables in the short and
long-run. Empirical evidence for Phillips curves.
The welfare effects of inflation and monetary policy:
Neutrality and superneutrality of money, welfare costs, seigniorage and the

inflation tax.
The Classical model, flexible price economies and monetary policy:
Rational expectations, representative agents and real business cycle theory. MIU,
CIA, Lucas supply functions and the effects of monetary policy.
The Keynesian approach to monetary policy – nominal rigidities:
Multi-period pricing and the persistence of monetary policy shocks. The Lucas
critique.
The new Keynesian approach to monetary policy – nominal rigidities:
New Keynesian Phillips curve, IS Curve, Taylor rules, financial accelerator models.
Section 3: Topics in monetary economics
Time inconsistency in monetary policy:
Inflation bias, the central bank independence. Monetary policy rules: interest rate
targeting and monetary targeting. (rules versus discretion).
8
1.4. Aims
Uncertainties in the monetary policy design:
News versus noise in data revisions. Brainard conservatism, certainty equivalence,

interest rate smoothing.
Term structure of interest rates:
Explanation of the yield curve: expectations hypothesis and the segmentation

hypothesis.
1.4 Aims
The aims of the course are to:
develop understanding of the theories that relate to the existence of money,

explaining why it is demanded by individuals and used in the trading process
develop an understanding of the monetary transmission mechanism, whereby

decisions made by the monetary authorities concerning money supplies or interest
rates can have real effects on the economy
develop a number of macroeconomic models through which monetary policy can be

evaluated. Such models will include Classical, Keynesian and new Keynesian
schools of thought and will consider why monetary policy matters and when
monetary policy decisions may be impotent
develop understanding of the uncertainties policy-makers face and how policy

makers may deal with these.
1.5 Learning outcomes

At the end of this course and having completed the essential reading and activities
students should be able to:
explain and discuss why people hold money and why it is used in the trading
process
solve macroeconomic models and assess the role and efficacy of monetary policy for
various types of models in both the Classical and Keynesian set-ups
describe and explain the main channels of the monetary transmission mechanism,
through which monetary policy can have real effects on the economy
discuss the merits and disadvantages of different monetary policies used by Central
Banks
introduce the concepts of data and parameter uncertainties and discuss policy
under uncertainty.
9
1.6 Subject chapters
A different chapter is devoted to each major section of the syllabus, and the chapter
order follows very closely, though not identically, the order of the topics as they appear
in the syllabus. This order will not concur with that in any one of the recommended
textbooks and the fact that the order varies between the textbooks themselves reflects
the view that there is no obvious sequence of topics because of the interrelationships
between them. It is most important to appreciate that the ‘topics’ in the syllabus are
not self-contained and mutually exclusive, and neither therefore are the chapters of this
guide. Instead there is considerable overlap between many of the ‘topics’ and between
the chapters. For example, the chapter on ‘the demand for money’ explains the link
between the level of real money balances an economy wishes to hold and the nominal
interest rate. This is essential for understanding how monetary policy influences the real
economy in later chapters. Similarly, an understanding of how, and to what extent,
changes in the supply of money affect the macroeconomy will require an understanding
of the subject matter of several chapters.
Consequently, you must expect the examination to include questions that require an
understanding of several different parts of this subject, in other words you cannot ‘pick
and choose’ what to study from the guide.
Each chapter begins with a checklist of learning outcomes; what you should know after
having completed the chapter and done the essential reading and activities. Then
follows some reading advice and a list of the most helpful books and articles for that
particular chapter. Following the main text, each chapter concludes with a list of
Sample examination questions. Occasionally these questions will overlap with material
covered in one or more of the other chapters.
1.7 Reading advice
Unfortunately no single textbook adequately covers the whole of the EC3115

Monetary economics syllabus. Indeed, using several different textbooks may still not
prove adequate. Sometimes it will be necessary to consult a ‘specialist’ book, or perhaps
an article in a journal in order to get a good grasp of the subject matter concerned.
Consequently, the reading suggested at the beginning of each chapter might include not
only references to one or more textbooks, but also references for wider reading. In some
chapters, it might be useful to study the recommended reading before you move on to
the material presented in the subject guide. Where this is the case, the introductory
paragraph will let you know what you should read before you work through the chapter.
For each chapter, the reading list is split into two sections: Essential reading and
Further reading. As the name suggests, Essential reading is required reading in order
for you to fully understand the concepts introduced in the particular chapter. Again, it
must be stressed that this subject guide is not a substitute for reading textbooks. The
items listed under Further reading will give you greater insight into the topics covered
in the chapter and will certainly help you understand any areas with which you still feel
uncomfortable.
10
1.8. Essential reading
1.8 Essential reading

For Sections 1 and 2, you are encouraged to buy:
either
Lewis, M.K. and P.D. Mizen Monetary Economics. (Oxford; New York: Oxford
University Press, 2000) [ISBN 9780198290629]
or
Carlin,W. and D. Soskice Macroeconomics: Imperfections, Institutions and Policies.

(Oxford: Oxford University Press, 2006).
For Sections 1 and 2 the Carlin and Soskice and Lewis and Mizen books are very
helpful. Carlin and Soskice book provides an excellent account of new Keynesian models
in particular, while Lewis and Mizen is easier to read. For Section 3, there is no single
book that is adequately covering issues addressed in the guide. We indicate relevant
literature in academic journals.
Throughout this guide, there are references in both the Essential and Further reading
sections to articles in The New Palgrave Dictionary of Money and Finance. This
includes essays and articles on most aspects of money, contributed by authors who are
internationally recognised authorities on the subject matter of their particular entry. In
each chapter you will be directed to the relevant entries in this book in either the
Essential or Further reading categories. Other books are particularly useful on specific
topics (such as money demand). Where such books (and indeed articles as well) are
recommended, page references or chapter numbers are given.
Detailed reading references in this subject guide refer to the editions of the set
textbooks listed above. New editions of one or more of these textbooks may have been
published by the time you study this course. You can use a more recent edition of any
of the books; use the detailed chapter and section headings and the index to identify
relevant readings. Also check the virtual learning environment (VLE) regularly for
updated guidance on readings.
The Essential reading for all chapters in this subject guide is taken from the two
textbooks above but also includes the following:
Books
Cagan, P. ‘The monetary dynamics of hyperinflation’, in Friedman, M. (ed.)

Studies in the Quantity Theory of Money. (Chicago: University of Chicago Press,
2000) [ISBN 9780226264042].
Gali, J. Monetary Policy, Inflation, and the Business Cycle: An Introduction to the
New Keynesian Framework. (Princeton: Princeton University Press, 2008) [ISBN:
9781400829347].
Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan,

1989) second edition [ISBN 9780262570756].
11
Gordon, R.J., ‘A century of evidence on wage and price stickiness in the US, the
UK and Japan’, in Tobin, J. (ed.) Macroeconomics, Prices and Quantities. (Oxford:
Blackwell, 1983) [ISBN 9780815784852].
Jones, C.I. Macroeconomics. (W. W. Norton Company, 2013) third edition [ISBN
9780393923902].
Laidler, D.E.W. The Demand for Money: Theories, Evidence and Problems. (New
York: Harper Collins, 1997) fourth edition [ISBN 9780065010985].
Lucas, R.E. ‘Econometric policy evaluation: a critique’, in Brunner, K. and A.H.

Meltzer (eds) The Phillips Curve and Labor Markets. (Amsterdam; Oxford:
North-Holland, 1976) [ISBN 9780444110077].
Mankiw, N.G. Macroeconomics. (New York: Worth Publishers, 2012) eighth edition
[ISBN 9781429240024].
McCallum, B. Monetary Economics. (New York: Macmillan; London: Collier

Macmillan, 1989) [ISBN 9780023784712].
Mishkin, F.S. The Economics of Money, Banking and Financial Markets. (Boston,
Mass.; London: Prentice Hall, 2012) tenth edition [ISBN 9780132770248].
Newman, P., M. Milgate and J. Eatwell (eds) The New Palgrave Dictionary of
Money and Finance. (London: Macmillan, 1994) [ISBN 9780333527221].
Williamson, S. Macroeconomics. (New Jersey: Prentice Hall, 2013) fifth edition

[ISBN 978-0132991339].
Journal articles
Aksoy, Y. and T. Piskorski, ‘US domestic money, inflation and output’, Journal of
Monetary Economics, 53, 2006, pp.183–197.
Bernanke, B. , Gertler, M., and S. Gilchrist (1999) ‘The financial accelerator in a

quantitative business cycle framework’, Chapter 21, in Handbook of
Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford, Elsevier.
Brainard, W., ‘Uncertainty and effectiveness of policy’, American Economic Review
(papers and proceedings), 57 (2), 1967, pp.411–425.
Carlin, W. and D. Soskice ‘The 3-equation New Keynesian model – A graphical

exposition’, BE Journals in Macroeconomics: Contributions, 5(1) 2005, pp.1–38.
Clarida, R., Gal, J. and Gertler, M., ‘The science of monetary policy: a new
Keynesian perspective’, Journal of Economic Literature, 37(4), 1999, pp.1661–1707.
Kydland, F.E. and E.C. Prescott, ‘Rules rather than discretion: the inconsistency
of optimal plans’, Journal of Political Economy 85(3), 1977, pp.473–492.
Long, J. and C. Plosser, ‘Real business cycles’, Journal of Political Economy 91(1),
1983, pp.39–69.
12
1.9. Further reading
Lucas, R., ‘Some international evidence on output-inflation trade-offs’, American

Economic Review, 63, 1973, pp.326–334.
Plosser, C., ‘Understanding real business cycles’, Journal of Economic Perspectives

3(3) 1989, pp.51–77.
Taylor, J.B., ‘An historical analysis of monetary policy rules’, NBER working
paper, w6768, (1998).
1.9 Further reading

Please note that as long as you read the Essential reading you are then free to read
around the subject area in any text, paper or online resource. You will need to support
your learning by reading as widely as possible and by thinking about how these
principles apply in the real world. To help you read extensively, you have free access to
the VLE and University of London Online Library (see below).
1.10 Online study resources

In addition to the subject guide and the Essential reading, it is crucial that you take
advantage of the study resources that are available online for this course, including the
VLE and the Online Library.
You can access the VLE, the Online Library and your University of London email
account via the Student Portal at: http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with your official
offer, which was emailed to the address that you gave on your application form. You
have probably already logged in to the Student Portal in order to register! As soon as
you registered, you will automatically have been granted access to the VLE, Online
Library and your fully functional University of London email account.
If you forget your login details, please click on the ‘Forgotten your password’ link on the
login page.
The VLE
The VLE, which complements this subject guide, has been designed to enhance your
learning experience, providing additional support and a sense of community. It forms an
important part of your study experience with the University of London and you should
access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own understanding of
subject material.
Electronic study materials: The printed materials that you receive from the
University of London are available to download, including updated reading lists
and references.
13
Past examination papers and Examiners’ commentaries: These provide advice on

how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss interests and
experiences, seek support from your peers, work collaboratively to solve problems
and discuss subject material.
Videos: There are recorded academic introductions to the subject, interviews and
debates and, for some courses, audio-visual tutorials and conclusions.
Recorded lectures: For some courses, where appropriate, the sessions from previous
years’ Study Weekends have been recorded and made available.
Study skills: Expert advice on preparing for examinations and developing your
digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we are expanding our
provision all the time and you should check the VLE regularly for updates.
Making use of the Online Library
The Online Library contains a huge array of journal articles and other resources to help
you read widely and extensively.
To access the majority of resources via the Online Library you will either need to use
your University of London Student Portal login details, or you will be required to
register and use an Athens login: http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the Online Library is
to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try removing any
punctuation from the title, such as single quotation marks, question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
1.11 How to use this subject guide

At the start of most chapters you are advised on how to approach the material and
which readings to consult as well as when to consult them. In general though, for each
topic in the syllabus you should read through the whole of the chapter in the guide so
as to get an overview of the material to be covered. Then try to read as much of the
suggested reading as you can. This is important as you will often find that things you
have difficulty understanding in one book are made perfectly clear in another. A
thorough understanding of the material covered in recommended passages is essential if
you are to maximise the benefits you derive from this subject.
Use the checklist and Sample questions as a way of testing your understanding of the
material covered. The textbooks will also include exercises and questions, and you
would be well advised to attempt as many of these as you can. The real test of whether
14
1.12. The examination
you understand something is not whether you have followed the explanation, but
whether you can apply that understanding to answering questions.
A number of chapters include a substantial activity. This is a longer question, which
you should be able to work through after having consulted the relevant readings.
Although an outline of the solution is included at the end of the chapter, you are
strongly encouraged to use this only to check your answers or to get hints as to how to
start your answer.
You should allocate approximately two weeks to study each chapter. Chapters 1 and 2
contain relatively little mathematical material, therefore can easily be dealt with in one
week.
1.12 The examination

Important: the information and advice given here are based on the examination
structure used at the time this guide was written. Please note that subject guides may
be used for several years. Because of this we strongly advise you to always check both
the current Regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow those instructions.
Examination questions will require short essays, demonstrating understanding of the
subject material and critical ability.
The three-hour unseen examination consists of two sections:
Section A (40 marks) contains eight statements, which are true, false or uncertain.
You will be asked to answer all of these, also explaining your answer in a short
paragraph. A typical ‘true, false or uncertain’ question will appear at the end of
each chapter and in the first half of the guide a suggested answer is also included,
in order to give you an idea as to how detailed the explanation should be.
Section B is worth 60 marks. You must answer three out of five questions. These
will typically involve discussing and solving some of the models covered in the
guide. These may also involve interpretation of data in the light of specified
macro-monetary theories.
To give you an idea as to how the examination will be structured, an example is
included in the Appendix. In addition to the Sample examination paper, the questions
at the end of each chapter will also give you an insight into the examination. The ‘true,
false or uncertain’ question in each chapter is representative of the questions you will be
asked in Section A and the remaining questions are similar to those found in Section B.
The longer activities, found in a number of chapters, are exactly the type of question
you should expect to find in Section B of the examination.
To give you an idea as to how you should structure your answers in the examination,
feedback to some of the Sample examination questions is given at the end of each
chapter. However, as is the case for the feedback to the longer activities, you should
only use this to check your answers, or to get hints as to how to start.
15
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements for this course
where available, past examination papers and Examiners’ commentaries for the
course which give advice on how each question might best be answered.
1.13 Use of mathematics and statistics

Economics is becoming an increasingly technical subject and, as such, in this subject
you will be required to employ mathematics in order to solve simple optimisation
problems. However, what is most important is the intuition behind the models, which
can often be demonstrated easily using diagrams. Any mathematics that is used in this
subject is limited to simple calculus (differentiation), algebra and basic statistics (the
definition and calculation of means and variances). The most technically demanding
chapters are from Chapter 7 to Chapter 12 but in order to help you work through this,
the mathematics is presented so as to allow you to see how the models are solved,
step-by-step. Some of the passages in some of the recommended books and articles do
contain more complicated or lengthy mathematics/statistics but almost invariably its
meaning is clarified in the written text.
Model-based approach of the guide
This subject guide follows a more model-based approach to monetary economics than
the previous guide. Each chapter introduces one or more models that, when solved, will
show you the linkages between monetary variables (money supply or interest rates, for
example) and other variables such as output. As such, for the examination you will be
expected to solve and work through mathematical models but these will be no more
complicated than what is presented in this subject guide. However, what is just as
important is that you demonstrate that you understand what is going on. To do this,
you must explain your answer using words, and possibly also diagrams. Even though all
you need to know to succeed in your study of monetary economics is presented in the
essential and further reading sections of each chapter, for those of you who require more
help with this model-based approach, you can consult Walsh, C. Monetary Theory and
Policy (2010) third edition and Gali, J. Monetary Policy, Inflation and the Business
Cycle (2008). It should be stressed, however, that you should read the items in the
recommended reading sections first, before you consider reading these more
advanced/technical textbooks. Hopefully you will find your study of monetary
economics interesting and enjoyable.
Good luck.
Dr. Yunus Aksoy (Birkbeck, University of London)
16
Chapter 2
The nature of money
2.1 Introduction
Fiat money is indispensable in modern economic systems, although it has been part of
daily life as far back as 9000 BC, when grain and cattle were used in Anatolia and
Mesopotamia for exchange purposes. While we take the usage of some form of money as
granted, we need to understand why it exists, its functions and properties. In particular,
we need to solve the double coincidence of wants problem associated with barter and to
resolve the lack of trust between the payer and the payee in a transaction.
2.2 Aims
The aim of the chapter is to introduce the main ingredients of a monetary economy. We
will introduce money for exchange purposes of goods and services. We will describe its
functions, why money is useful in trade, its types and properties.

By the end of this chapter, and having completed the Essential reading and activities,
you should be able to:
discuss the nature and shortcomings of a barter economy
list and describe the general functions performed by money
describe the Wicksell problem and demonstrate how indirect barter can lead to the
emergence of a commodity money
describe the differences between transactions using credit cards and bank debit
cards
list and describe what the different types of money are.
2.4 Reading advice

You will certainly find it easiest, and probably most useful, to read the appropriate
sections on the nature of money in one or more of the basic textbooks before you move
17
2. The nature of money
on to the material in this chapter.1 All textbooks on money and banking will have a
section covering the material here. However the best, although most difficult, is that of
Goodhart (1989a) Chapter 2 – see below under ‘Essential reading’. You may find it
helpful to read Goodhart (1989b) first – see below under ‘Further reading’.

Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan, 1989a)
Chapter 2.
University Press, 2000) Chapters 1 and 2.
2.6 Further reading

Clower, R.W. ‘Introduction’ in Clower, R.W. (ed.) Monetary Theory: Selected readings.
(Harmondsworth: Penguin, 1969).
Goodhart, C.A.E. ‘The Development of Monetary Theory’ in Llewellyn, D.T. (ed.)
Reflections on Money. (Basingstoke: Macmillan, 1989b).
Harris, L. Monetary Theory. (New York; London: McGraw-Hill, 1985) Chapter 1.
Kiyotaki, N. and J.H. Moore ‘Evil is the Root of all Money’. Clarendon Lecture series,
Lecture 1 (2001).
Kiyotaki, N. and R. Wright ‘Acceptability, Means of Payment, and Media of Exchange’,
Federal Reserve Bank of Minneapolis Quarterly Review, Summer 1992. Also in Newman,
P., M. Milgate and J. Eatwell (eds) The New Palgrave Dictionary of Money and
Finance. (London: Macmillan, 1994).
McCallum, B. Monetary Economics. (New York; Macmillan; London: Collier
Macmillan, 1989).
Newlyn, W.T. and R.P. Bootle Theory of Money. (Oxford: Clarendon Press, 1978)
Chapter 1.
2.7 What is money?

Money is defined by its function rather than the form in which it takes. In this sense,
money is defined as ‘anything which is in general use, and generally accepted, as a
means of payment.’ In the past, money has taken the form of corn, rice, cattle, shells,
various precious metals and more recently, pieces of paper issued by governments. In all
cases though, money was and is used as a means of payment in exchange. The payer in
a transaction (he or she who is purchasing a good or service) hands over money to the
value of the item bought and at this point the payee (the seller of the good or service)
1
See for example, Harris, and Newlyn and Bootle.
18
2.8. The functions of money
accepts that the payment is complete. The payee neither holds any further claims on
the payer, nor on any third party who may have produced or issued the money.
In this chapter we will discuss and explain the important functions, properties and
different types of money. We will also explain why we use money and compare the
alternative trading strategies, both with and without money.
2.8 The functions of money
Below, we will discuss the three main functions of money, although, arguably, some
authors will expand these into four.2
Money as a means of payment
As suggested above, the most important function of money is its use as a means of
payment – money being used to pay for items purchased or to settle any debts. A
related role of money is that as a medium of exchange, which Wicksell defined as an
object which is taken in exchange, not on its own account. . . not to be consumed by the
receiver or to be employed in technical production, but to be exchanged for something
else within a longer or shorter period of time.’3 In this sense, a means of payment can
also be a medium of exchange. A gold coin for example, used to buy a piece of land, will
be a means of payment (the seller of the land will not hold a claim on the payee who
has just handed over the gold) but it will also be a medium of exchange. The receiver of
the gold coin will not use it for decorative purposes or to ‘make’ any other goods or
services, but will use it as a medium of exchange when he or she wishes to purchase a
good or service some time in the future.
However, the converse is not necessarily true.4 That which may act as a medium of
exchange may not act simultaneously as a means of payment. For example, if I wish to
pay for a television set using a credit card, the seller may accept this as a medium of
exchange.
Although the television shop’s account may be credited effectively immediately, it may
not be a means of payment since I, the payer, still have a debt outstanding, namely that
to the credit card company. I have merely replaced a debt to the television shop with a
debt to the credit card issuer. The purchase of the television set with the credit card is
then not a means of payment. For this reason we will not include credit cards, trade
credit between firms, or any other line of credit such as unused overdraft facilities, in
our definition of money.
2
The fourth function of money commonly quoted, is that of a standard for deferred payment. This
simply means that if something is bought today although payment for it does not have to be made until
some later date, then the amount due for deferred payment can be measured in terms of money.
3
Wicksell, 1906, quoted by Kiyotaki and Wright, (1992).
4
For an excellent analysis of the differences between ‘means of payment’ and ‘medium of exchange’
see Goodhart (1989a) Chapter 2, Section 4.
19
Money as a unit of account
This function is also described as money acting as a measure of exchange value, money
acting as a standard of value, or money as a numeraire. The essential point about this
function is that money is acting as a common denominator, in terms of which the value
in exchange of all goods and services can be expressed. Money is simply acting as a unit
of measurement in the same way that metres measure length and kilograms measure
weight. Money in this sense is being used to measure the value of goods, services and
assets relative to other goods, services and assets. If it is convenient to trade all
commodities in exchange for a single commodity, so it is convenient to measure the
prices of all commodities in terms of a single unit, rather than record the relative price
of every good in terms of every other good. If there is to be a single unit of account, it is
again clearly convenient (though not necessary) that the unit of account be the medium
of exchange, given that goods actually exchange against the medium of exchange.
A clear advantage of having a single unit of account is that it greatly reduces the
number of exchange ratios between goods and services. With four goods (A, B, C and
D), in order to facilitate exchange, exchange ratios of each good in terms of all the
others must be available (i.e. the six ratios A:B, A:C, A:D, B:C, B:D and C:D must be
available). In fact with n goods, there are n(n − 1) = 2 relative prices. However, if we
introduce a fifth good, ‘money’ that acts as a unit of account then there only need to be
four prices. With n goods and money being the n + 1-th commodity acting as a unit of
account, we only need n prices. For example, with 1,000 goods and no unit of account,
the economy needs 499,500 relative prices of one good in terms of another. Introducing
money as a unit of account dramatically reduces this to only 1,000. Thus, having money
as a unit of account can encourage trade by making it easier for individuals to know
how much one good is worth in terms of another.
Money as a store of value
The exchange attributes of money, in particular that it is durable and can readily be
used in the purchase of goods, also mean that people may wish to hold it as an asset,
that is as part of their stock of wealth. In this sense, money serves as a store of value: it
is permitting the separation in time of the act of sale from the act of purchase. The
existence of a means of payment enables a person to sell a good without simultaneously
having to buy another good in exchange. Receiving a means of payment in exchange for
the good sold allows the seller to hold on to it until such time as it is needed to be
exchanged for the goods and services he or she requires.
Money is not unique as a store of value: any asset, such as equities, bonds, real estate,
antiques and works of art can all act as stores of value. Money itself is sometimes a poor
store of value. This will occur when the relative price of money falls as a result of the
money prices of other goods and services rising, that is, during periods of inflation.
2.9 Why do we have money?

The use of money helps facilitate trade since in the absence of money, trade has to
proceed through barter, that is the direct exchange of one good for another.
20
2.9. Why do we have money?
Barter
Barter tends to be associated with primitive economies in which individual households

operate in an isolated manner, and in particular have no sophisticated information
systems concerning what is going on in the rest of the economy. For various reasons
households may wish to consume a different bundle of goods from those they produce,
so that there are gains from trade. The problem is how to achieve these potential gains,
given that trade is a voluntary activity and can proceed only when it is to the benefit of
both parties.
In barter, there has to be what is known as a ‘double coincidence of wants’. If I grow
corn but want to consume apples, not only do I have to find someone willing to trade
apples but they must also want what I have to offer, namely corn. In other words for
trade to be mutually beneficial, it is necessary not only that trader A has what trader B
wants but also that trader B has something to offer in exchange which trader A wants.
It is quite possible that no trade will occur, especially in cases where the goods desired
are so specialised that the probability of a double coincidence of wants occurring is so
low that the cost of finding a match (for example in terms of advertising, transport, and
so on) becomes very large and outweighs the increased utility derived from trade. Even
if the goods offered for trade are readily available, it may still be the case that no trade
occurs. This is the subject of the Wicksell problem in which it is impossible to secure
gains from trade through bilateral exchange.
The Wicksell problem
Consider the situation in Table 2.1 and shown in Figure 2.1. There are three individuals
who each only produce one good but derive more utility from the consumption of
another. Avinash produces bread but wants wine, Nicole produces wine but wants
apples and Edwin has apples but wants bread. In this situation, no bilateral exchange
will result. Edwin will not trade with Nicole since he derives more utility from
consuming his own apples than he does from Nicole’s wine. The utility maximising
situation is shown in Figure 2.1 but under the assumption of no commitment, this will
never arise. Avinash will not want to give his bread to Edwin, hoping to receive wine
from Nicole since after receiving bread, Edwin has no incentive to give apples to Nicole
who in turn will have no incentive to hand over her wine to Avinash. The system will
collapse to autarky (in which all individuals become self-sufficient).
However, models of this type can lead to the emergence of indirect barter. In indirect
barter a trader accepts a good not because she or he wants to consume it but because of
the possibility that it may result in a future trade. In the above example, Avinash may
trade his bread for apples, not because he wants to consume the apples but in the
knowledge that when meeting Nicole, she will be willing to trade her wine for those
goods. This may seem an obvious solution at first glance but if we assume traders meet
at random (or do not know how long it will be before they meet a prospective trader)
then considerable risk may be taken on in this transaction. The goods Avinash accepts
in exchange for his bread may deteriorate before he meets Nicole, in which case Nicole
will not want to trade.
Let us assume that the apples do not perish. The situation of indirect barter is shown in
21
Table 2.1:
Figure 2.1:
Figure 2.2.
If apples are used in both stages of the trading process then each trader will gain. In
indirect barter, commodities are acquired not for consumption but for the purposes of
making future exchanges. They should therefore have appropriate physical attributes; in
particular they should be durable, portable and homogeneous (or at least easily valued).
In primitive societies money emerged from the process of indirect barter, and took the
form initially of staple foodstuffs like corn or rice. With the development of
technologies, which allowed the separation of metals, money increasingly took the form
of precious metals, especially gold.
Money and trust
The solution of indirect barter in the Wicksell problem arises almost entirely from the
lack of trust between traders. As shown in Figure 2.1, each trader could maximise
utility by giving his or her goods to the next person in the triangle. However, Avinash
could not trust Edwin to hand over his apples to Nicole once he gave him his bread and
neither could he trust Nicole to hand over her wine once (or if) she received Edwin’s
22
2.9. Why do we have money?
Figure 2.2:
apples.
Let us consider another situation. Suppose I visit my dentist and I pay for his services
using a bank debit card.5 The bank will debit my account and credit that of the dentist.
I have effectively given an IOU6 to the bank and the bank has given the dentist one of
its IOUs. But why did I not just hand over one of my IOUs directly to the dentist?
Perhaps it may be that my dentist does not trust me to repay once he tries to redeem
my IOU. More realistically, he cannot use my IOU to make purchases with anyone else
and the likelihood that he will ever want to redeem the IOU from me, by receiving an
economics lesson, may be so small that he would never have agreed to spend his time
fixing my teeth. If the dentist went to the grocers the following day trying to buy
provisions with an IOU from an economics teacher, of whom the grocer had never
heard, it is highly unlikely that the trade would be completed. On the other hand, if he
tried to pay using the bank’s IOU, the grocer should happily agree to the sale, purely
because everyone knows and trusts the bank.
The difference between my IOU and that of the bank is that the bank’s IOU is liquid
5
This example is taken directly from ‘Evil is the Root of all Money’ by Kiyotaki and Moore (2001).
The model presented in this paper is not necessary for this subject but the ideas discussed therein will
greatly improve the reader’s intuition as to what is money and why we hold it.
6
‘IOU’ is short for ‘I owe you’ and is merely a written statement acknowledging that a debt has been
created, to be repaid sometime in the future.
23
and functionally equivalent to cash. My IOU, on the other hand, is not liquid and
cannot flow around the economy facilitating trades. As we will discuss later in this
chapter, it is ‘credit’ money but serves the same purpose as the commodity money
derived in the indirect barter problem, without having to use or lock up any goods in
the payment process.
Activity 2.1 Consider the problem in Figure 2.1. How could you introduce a bank
and a system of IOUs to resolve the problem without having to use any commodity
to act as a medium of exchange?
The idea of trust and uncertainty are important ones when explaining the existence of
money.7 If you do not know, or have any way of obtaining information as to the
creditworthiness of, a prospective customer, there is a high risk that he or she may
default on that debt. The risk is, however, minimised if the payer hands over an item of
worth, such as commodity money or another store of value, or an IOU redeemable from
a third party on which the payee has sufficient information, such as a bank. In this way
it may be essential to hold money beforehand in order to make purchases. This is the
whole idea behind ‘cash in advance’ (CIA) models that we will consider in a more
macroeconomic setting in later chapters. People have to hold money in order to
alleviate the problem of trust (or lack of trust) when transactions are made.
2.10 Types of money

Up to now we have considered only two types of money: commodity money in the
solution to the Wicksell problem, and credit money as the solution to the lack of trust in
the issuance of private IOUs. Traditionally, however, money is divided into three types:
commodity money
fiat money
credit money.
Commodity money
Commodity money derives from the use of commodities as exchange intermediaries in

indirect barter. Commodity money has taken many forms, such as cattle, corn, seashells
and suchlike, but in most societies, it has evolved towards the precious metals, copper,
silver and, above all, gold. Such commodities are accepted in exchange because of their
intrinsic value, even though the trader intends to use them in further exchange rather
than for their own consumption. Commodity money is inefficient, in part because the
commodities being used may not have ideal properties as exchange intermediaries but
more fundamentally because it is unnecessary to use goods which have intrinsic value
for a purpose which does not make use of that value. For example, using gold as a
commodity money does not make use of the fact that gold does have some alternative
utility-yielding use and could be used in more satisfying ways, such as through jewellery
or ornaments.
7
On this issue, see Goodhart (1989a), Chapter 2, Section 2.
24
2.10. Types of money
Fiat money
Fiat money, whose archetype is the government-issued bank note or metal coin, is
money that has physical substance but no intrinsic value. It is used because its use is
established by custom and practice. People accept fiat money that they know to be
intrinsically worthless because they know others will accept it in payment for goods and
services. The value of fiat money is reinforced in society by the attribute of being ‘legal
tender’, that is making it illegal for anyone to refuse payment in fiat money in
settlement of a debt. In fact it is this legal ‘stamp’ and recognised power of the issuer,
usually governments, which gives fiat money its unquestionable acceptance as a means
of payment.
Since fiat money is essentially worthless, there is a difference between the value of the
goods such money can purchase and the smaller cost of printing this money. The
difference is known as seigniorage and is effectively the profit made by the issuing
authority when it produces currency.
Credit money
Whereas fiat money is not a claim on any commodity or individual, credit money is; it
is the debt of a private person or institution. In the dentist example above, I gave an
IOU to the bank, which in turn hands this debt over to the dentist. If he can pass this
claim on to another individual, the grocer, in exchange for goods, then this debt is
being used as a means of payment and so constitutes money. However, the asset that
the grocer now has, the claim on the bank, is matched one-for-one with the bank’s
claim on me. What the bank owes to the grocer (the bank’s liability) must be matched
by what I owe the bank (the bank’s asset) in order for the bank’s balance sheet to
balance. The limitation of credit money is that it can only function if both individuals,
the dentist and me in the example, have complete confidence in the willingness and
ability of the intermediary to honour the debt. If the bank fails then both my dentist
and I would lose out since the dentist would still have a claim on me and I may not
have the funds to honour that claim if the bank has been forced to close. Since there
exists a private liability perfectly offsetting the asset acting as a means of payment (i.e.
the money is generated inside the private system) credit money is also known as ‘inside
money’. Fiat money, which cannot be matched against private sector claims (and is
generated outside the private sector) is in a similar fashion, known as ‘outside money’.
In the UK today, inside money is quantitatively much larger than outside money. At the
time of writing, the nominal value of inside money is approximately 30 times the value
of outside money, notes and coins.
There may appear to be a contradiction at this point when we compare the definition of
credit money to the discussion in the section ‘money as a means of payment’ where we
argued that all forms of credit should not be included in our definition of money. In the
above example, although I have replaced a debt to my dentist with a debt to my bank,
this is commonly accepted as a means of payment since a transfer of credit to a current
account has advantages such as safe-keeping and making use of book-keeping services at
the bank. Only when all parties concerned are entirely confident the bank will not fail,
will such transfers be a means of payment. Once the bank hears of my purchase at the
dentist (via the swiping of the debit card), the bank debits my account and credits that
25
of the payee, the dentist. Nothing further needs to be done since the payment is
complete. If a purchase is made by credit card, however, a debt is still outstanding and
has to be repaid. Similarly, if I paid by my bank debit card but went overdrawn, a debt
would remain outstanding which I would later have to pay off. For this reason, overdraft
facilities are not a means of payment.
2.11 Properties of money

When discussing the appropriate properties of commodity money, we mentioned
durability, portability and that it should be homogeneous. Other necessary properties
are divisibility and recognisability. In fact all money should possess these properties:
electronic transfers when purchases are made by bank debit card are themselves
durable, if not in a physical sense, in that $1 credited to your account does not
deteriorate over time. Another property that is just as important is that of
acceptability, the probability that it will be accepted as a means of payment. Kiyotaki
and Wright (1992) emphasise this property and argue that acceptability is not a
property of the money per se. An equilibrium can be reached where one individual uses
one money purely because they believe everyone else will use it:
‘When an object is more readily acceptable to other people in the economy, it

is more likely that each individual will desire it and accept it as a medium of
exchange. The implication is that the property of acceptability can have a
self-reinforcing nature. . . (This) lead(s) to the conclusion that acceptability
may not actually be a property of an object as much as it is a property of
social convention.’
Kiyotaki and Wright, 1992, p.19.
2.12 A reminder of your learning outcomes

discuss the nature and shortcomings of a barter economy
list and describe the general functions performed by money
describe the Wicksell problem and demonstrate how indirect barter can lead to the
emergence of a commodity money
describe the differences between transactions using credit cards and bank debit
cards
list and describe what the different types of money are.
26
2.13. Sample examination questions
2.13 Sample examination questions

Section A
Specify whether the following statement is true, false or uncertain. Explain your answer
in a short paragraph.
1. ‘The evolution of commodity money from indirect barter, as the solution to the
Wicksell problem, arises because of a lack of trust between the relevant parties.’
Section B
2. In a monetary economy, money usually performs the three roles of medium of

exchange, unit of account and store of value. Why are these three roles typically
combined in one entity? Is it possible to conceive of an economy in which they are
performed by three separate entities?
3. What is money and why do we use it? Outline the three different types of money
and explain what is different between them.
4. ‘Money should essentially be perceived as an instrument that allows an increasingly

widespread and anonymous economic society to deal with the inevitable resulting
shortcomings in information and trust of each of the members on the others.’
(Goodhart) Explain and discuss.
5. Explain why some economists argue that payment by cheque is the same as giving
trade credit. If this is the case and considering that cheques are drawn on bank
current accounts (as are payments by bank debit cards), do cheque payments count
as money?
2.14 Feedback to Sample examination questions

Section A
1. The statement is true. Suggested answers may include Figure 2.1 and an
explanation as to why each person cannot trust the others to pass their goods
along the chain. In the example of Figure 2.1, Avinash could not trust Edwin to
hand over his apples to Nicole once he gave him his bread and neither could he
trust Nicole to hand over her wine once (if) she received Edwin’s apples. By using a
commodity money, such as wine, the problem can be solved. Edwin trades his
apples for Nicole’s wine, not because he wants to consume the wine, but because he
can trade it with Avinash for his bread. Wine is thus being used as a commodity
money.
27
Section B
3. Money is anything which is in general use, and generally accepted, as a means of

payment. Although money has a number of functions, including unit of account
and store of value, it is its use as a means of payment that defines it. The main
reason why money is used is to avoid the problems associated with barter, namely
the double coincidence of wants. You could discuss the origins of a commodity
money here, from the Wicksell problem, and also explain how money solves the
lack of trust problem in a world of largely anonymous individuals. The three types
of money are: commodity money, fiat money and credit money. All these are
described near the end of this chapter.
28
Chapter 3
The demand for money
3.1 Introduction
In Chapter 2 we saw why there was a need for money:
to solve the double coincidence of wants problem associated with barter
to obviate the lack of trust between the payer and the payee in a transaction.
However, what determines the quantity of money that individuals and economies
demand is a separate question. It is the aim of this chapter to explain what determines
the quantity of money we demand and also to present a number of models (or theories)
of the demand for money. The chapter is split into two main sections. The first part
considers the demand for money from individuals or institutions/firms the
microeconomic determinants of money demand. The second part examines the demand
for money at the macroeconomic level gives a brief history of money demand, focusing
on the breakdown of the macroeconomic demand for money function.
3.2 Aims
The aim of the chapter is to study the money demand as one of the building blocks of
the money market equilibrium.

explain why it is important to study the demand for money
describe the four main microeconomic determinants of money demand
outline the inventory theoretic model of Baumol–Tobin and the portfolio selection
model of Tobin
discuss why Tobin’s model solves the ‘plunger’ problem of the demand for money
model of Keynes
describe the general set-up of macroeconomic money demand equations
29
3. The demand for money
discuss empirical evidence on money demand functions, especially on income and

interest elasticities
describe what happened and what is meant by ‘the case of the missing money’ and
give reasons for the breakdown of the estimated money demand equations.
3.4 Reading advice

Before embarking on this chapter, and before consulting any of the recommended
reading, you should review your understanding of ‘the demand for money’ from your
studies in EC2065 Macroeconomics. A very useful text on the demand for money is
Laidler (1993), which is both readable and comprehensive, and should be consulted on
everything covered in this chapter. Goodhart (1989) is also essential reading and should
be read while you work through the chapter.

Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan, 1989)
Chapters 3 and 4.
Laidler, D.E.W. The demand for money: Theories, evidence and problems. (New York:
Harper Collins, 1993) Section II.
University Press, 2000) Chapters 5, 6, 11 and 12.
3.6 Further reading

Books
Friedman, M. ‘The quantity theory of money: a restatement’, in Friedman, M. (ed.)

Studies in the quantity theory of money. (University of Chicago Press, 1956).
Goldfeld, S.M. ‘Demand for money: empirical studies’, in Newman, P., M. Milgate and
J. Eatwell (eds) The New Palgrave Dictionary of Money and Finance. (London:
Macmillan, 1994).
Goldfeld, S.M. and D.E. Sichel ‘The demand for money’, in Friedman, B. and F. Hahn
(eds) Handbook of monetary economics. (Amsterdam: North-Holland, 1990).
Harris, L. Monetary Theory. (New York; London: McGraw-Hill, 1985) Chapters 9 and
10.
Journal articles
Baumol, W. ‘The transactions demand for cash: an inventory theoretic approach’,

Journal of Econometrics (1952) 66, November, pp.545–56.
30
3.7. Microeconomic determinants of the demand for money
Judd, J. and J. Scadding ‘The search for a stable money demand function: a survey of
the post-1973 literature’, Journal of Economic Literature 20(2) 1982, pp.993–1023.
Miller, M. and D. Orr ‘A model of the demand for money by firms’, Quarterly Journal
of Economics 80(3) 1966, pp.413–35.
Sprenkle, C. ‘The uselessness of transactions demand models’, Journal of Finance 24(5)
1969, pp.835–47.
Tobin, J. ‘The interest elasticity of transactions demand for cash’, The Review of
Economics and Statistics 38(3) 1956, pp.241–47.
Tobin, J. ‘Liquidity preference as behaviour towards risk’, Review of Economic Studies
25(1) 1958, pp.65–86.
3.7 Microeconomic determinants of the demand for

money
There are essentially four main determinants of money demand at the individual level.
These are
1. interest differentials: the difference between the yield on money, commonly

assumed in the literature to be zero,1 and the rate of return on other assets. The
greater the rate of return on assets other than money, the greater the opportunity
cost of holding money, and so the fewer money balances will be demanded.
2. cost of transfers: the costs associated with transferring between higher interest
earning assets and money, needed to purchase goods and services. If the cost of
transfers, known as brokerage fees, are high then it is unlikely that we will put our
wealth into the higher interest earning assets as to do so will involve substantial
costs. Demand for money will then be a positive function of these transfer costs.
3. price uncertainty of assets: there is inevitably risk involved in holding assets.

Even though there exists a risk in holding money as a store of value, since we do
not know for certain how many goods a given quantity of money can buy in the
future due to inflation, the risk associated with holding other, interest earning,
assets is generally considered to be greater. If the price of assets is likely to vary
over time then, by the time we want to sell those assets in order to obtain money
to undertake transactions, we may face considerable capital loss. If we are
risk-averse then our demand for money will therefore be a positive function of the
riskiness or price uncertainty of alternative assets.
4. the expected pattern of expenditures and receipts: if individuals were paid

their wages in lump sums weekly then average cash balances would be less than if
wages were paid monthly. If the pattern of payments and receipts was uncertain
then cash balances would be likely to be higher; it may be unwise to face the
brokerage fees and transfer cash to bonds if there is a possibility that you will need
to make a large cash payment in the near future.
1
In practice the interest paid on sight deposit accounts is positive.
31
These determinants are also related to Keynes’ description of money demand motives.
Keynes (1936) broke down the demand for money into three types: transactions,
precautionary and speculative motives:
The transaction demand for money is essentially that needed to buy goods and
services where money is needed as a medium of exchange.
Precautionary money balances are simply holdings of money kept in case of

emergencies (an unexpectedly large tax bill or hospital treatment for example).
Finally, the speculative demand for money considers money as an alternative to

interest earning assets. Due to the capital loss involved with holding bonds when
the interest rate increases2 if an individual expects the interest rate to rise, then he
will expect to experience a capital loss on his bond holdings. Knowing that the
bond price will fall, he will want to hold a larger quantity of money.
In fact, Keynes originally assumed that individuals held their expectations of interest
rate movements with certainty. When the interest rate was below what they expected in
the long run, R∗ in Figure 3.1, then they would put all of their financial wealth in the
form of money to avoid the capital loss associated with holding bonds. When the
interest rate was above what was expected, then the expected interest rate fall would be
associated with a capital gain from holding bonds. The individual would then hold as
little money as possible, only covering the transactions and precautionary motives (T
representing minimum cash required to conduct transactions). The individual’s demand
for money, as a function of the interest rate, would then be a step function, shown in
Figure 3.1 below.
Figure 3.1:
2
This is due to the negative relationship between the price of a bond and the yield the bond earns.
This is considered in more detail in Chapter 9.
32
3.8. Baumol–Tobin transactions demand for money
It has become standard to model each component of the demand for money separately.3
The transaction demand for money is typically modelled by allowing money to be a
function of determinants 1, 2 and 4 above (i.e. ignoring asset price uncertainty). By
allowing more flexible assumptions on the expected pattern of expenditures and
receipts, similar analysis can incorporate a precautionary motive for money holdings.4
Analysis of the speculative demand for money, however, concentrates on determinant 3,
asset price uncertainty, while dropping one or more of the other factors for tractability.
3.8 Baumol–Tobin transactions demand for money

The two papers by Baumol (1952) and Tobin (1956) explicitly model the transactions
demand for money in an inventory theoretic approach. Each assumes that a cash
manager (individual or firm) has to manage an inventory of cash and other
interest-earning assets. In the original Baumol model, the cash manager is paid in bonds
and spends money (or makes transactions) at a constant, known rate. The objective is
to choose the number of times she transfers between the stock of bonds and cash that
maximises profits, or equivalently minimises costs. These costs come in two forms:
brokerage fees and the interest foregone by holding money. By making a large number of
transfers out of bonds and into cash, she will be able to earn more interest on the bonds
that are kept for longer. However, such a strategy will involve large brokerage fees. On
the other hand, by making only a few transfers, she will avoid paying frequent brokerage
fees but will miss out on the interest the wealth could earn if kept in the form of bonds.
Let T equal the value of the cash manager’s expenditures, equal in this case to her
income: i is the interest rate earned on bonds, b is the fixed cost of making a transfer
between bonds and cash and Z is the value of money transferred each time, equal to the
amount of bonds sold each time. If the money is spent at a constant, known rate then
the average money balances will be equal to M = Z/2. The cost minimisation problem
can be written as:
bT iZ
min C = + . (3.1)
Z Z 2
Costs, C, are made up of brokerage costs, equal to the cost per transfer, b, multiplied by
the number of transfers, T /Z, plus the interest foregone by (opportunity cost from)
holding money. The interest rate foregone will equal the interest rate, i, multiplied by
the average money holdings, Z/2. Differentiating the cost with respect to the choice
variable, Z, the amount we transfer each time, gives:
dC bT i
=− 2 + . (3.2)
dZ Z 2
Setting this equal to zero and solving for M = Z/2, gives:
r
Z bT
M= = . (3.3)
2 2i
The average money demand, M , is then a positive function of both the brokerage cost,
b, determinant number 2, and income/receipts, T , determinant number 4. It is also a
3
See Goodhart (1989) Chapter 3, Sections 1 and 2 for a more complete discussion of the modelling
techniques.
4
See Miller and Orr (1966).
33
negative function of the interest rate earned on alternative assets, i, determinant

number 1. One can also show that the interest and income elasticities of money demand
are −1/2 and 1/2, respectively. This is left as an exercise. So average money demand
will increase by 1/2% if income increases by 1% and decreases by the same amount if
the interest rate earned on alternative assets increases by 1%. The model generates a
‘saw tooth’ pattern of money holdings as shown in Figure 3.2 below. For simplicity,
assume that interest payments are made at the end and do not accrue during the period.
The diagram shows a situation where the optimal number of times to transfer between
bonds and money is 4. At time t0 , the cash manager receives T in bonds and transfers
Z to cash immediately in order to buy goods and services. The amount of bonds left is
therefore B1 (the difference between T and B1 being Z). Money balances and hence
financial wealth decline gradually as the cash is spent. At time t1 , another transfer is
made that reduces bond holding by a further Z to B2 . The process continues until all
wealth is spent and a new income is received. Money holdings are therefore shown by
the saw-tooth pattern, financial wealth is shown by the straight line from T and the
level of bond holdings is shown by the dashed step function.
Figure 3.2:
Activity 3.1 A taxi driver takes £15,000 net over the course of a year, at an
approximately constant daily rate. He spends 80% of his takings on consumption
goods, also at an approximately constant daily rate, but saves the remainder to pay
for a world cruise at the end of the year. He can hold his savings in a deposit
account in a bank paying 4% per annum, with costless deposits and withdrawals, or
he can purchase bonds paying a known yield of 7%. The brokerage fee in purchasing
or selling bonds is £5 per transaction. Assume the taxi driver manages his finances
34
3.9. Tobin’s model of portfolio selection
optimally by making n transactions, n − 1 of these being purchases of bonds spaced

equally through the year, and the n-th transaction being the sale of bonds at the
end of the year to pay for the world cruise.
(a) Draw the time profile of the taxi driver’s holdings of deposits and bonds.
(b) What is the optimal value of n? (Note that n must be a whole number.)
(c) What is the taxi driver’s ‘demand for money’, or average deposit balance?
(For Feedback, see the end of this chapter.)
Criticisms of the inventory theoretic model
Despite the intellectual appeal and simplicity of the inventory theoretic model, it faces a
number of criticisms. One argument made against such models is that they make the
assumption that the pattern of expenditure and receipts is known perfectly. This is
clearly not true in reality. Adding uncertainty to these processes is exactly what Miller
and Orr (1966) do but, even then, these inventory theoretic models face a huge uphill
struggle when faced with empirical evidence. At the micro level, the percentage of
actual cash balances held by firms that is explained by the Baumol model is tiny.
3.9 Tobin’s model of portfolio selection

One problem with Keynes’ original ideas of the micro level demand for money was that
individuals held expectations of interest rate movements with certainty. This resulted in
a step demand function given in Figure 3.1 where individuals either held no money and
all long term bonds (or as little money as possible to cover transactions) or held all
money and no bonds. Individuals were ‘plungers’ – all or nothing. This did not explain
the empirical regularity that people held their financial wealth in both forms of assets
and could only provide a downward sloping aggregate money demand function by
assuming that every individual had a different expectation of the equilibrium interest
rate, also assuming that each of these expectations were held with certainty. This
clearly is too strong an assumption.
To overcome this problem, Tobin (1958) considered the problem of how much money to
hold as one where individuals maximise utility by choosing between assets in a
portfolio. Money is assumed to have a zero rate of return and is considered riskless. The
variance of the return on money is then also zero. Bonds, however, pay a positive rate of
return, µ, but are risky due to the possibility of capital gains or losses if the bond is
sold before maturity. Let the variance of the return on bonds be σ 2 .
Let B be the proportion of your financial wealth held in bonds. 1 − B is therefore the
proportion held in the form of money if we assume a two-asset world. The distribution
of money and bonds are given below:
Money ∼ (0, 0) (3.4)
Bonds ∼ (µ, σ 2 ). (3.5)
35
A portfolio containing a share B of bonds and 1 − B of money therefore has a

distribution:
Portfolio ∼ (0 · (1 − B) + µ · B, 0 · (1 − B)2 + σ 2 B 2 ) = (µB, σ 2 B 2 ). (3.6)
Let the mean return of this portfolio be µp and the variance be σp2 .
µp = µB (3.7)
σp2 = σ 2 B 2 . (3.8)
Writing B in terms of σ and σp from (3.8) and substituting into (3.7) gives a budget
constraint relating the maximum return on a portfolio to the standard deviation, which
we assume is a proxy for risk.
µσp
µp = . (3.9)
σ
Assuming that agents are risk-averse, the indifference curves will be convex and upward
sloping, as shown in Figure 3.3.
The top part of the figure shows the budget constraint and indifference curves of the
agent. Note that there is an upper bound on the return and risk of the portfolio, µ0p and
σp0 , respectively, where the individual has put all of their financial wealth in bonds;
B = 1. At this point it is impossible to increase the return or risk of the portfolio by
substituting between money and bonds. The bottom part of the figure simply shows the
share of the portfolio held in bonds and the corresponding risk of the portfolio.
As can be seen in the figure, the individual maximises utility by being at the point
where the indifference curve is tangential to the portfolio budget constraint, point E.
The share of wealth held in bonds is B ∗ and the share held in money is 1 − B ∗ . By
using portfolio analysis, Tobin showed how individuals can diversify their wealth into
more than just one asset. By changing the return earned on bonds, µ, this will shift the
lines in the figure, resulting in a new equilibrium and different bond/money allocation
(see ‘Feedback to the Activity’ at the end of this chapter).
3.10 Macroeconomic determinants of money demand

As seen in the previous section and the models referenced there, money demand at the
micro level is modelled as a function of a number of variables: interest differentials, cost
of transfers, asset price uncertainty and the pattern of expenditures and receipts. At the
macro level, however, the demand for money is modelled under, arguably, a simpler
framework. That is not to say that the analysis is simpler or there are fewer
complications to overcome. Indeed, the econometric techniques used to model the
aggregate demand for money are complex and have needed to be after the breakdown of
the demand for money functions starting in the 1970s.
The demand for money is one of the most thoroughly researched topics in the field of
economics but why has it attracted so much attention? We study the demand for
something in order to be able to predict the consequences of changes in its supply, and
this is as true of money as of anything else. Changes in the supply of any good, service
or asset will alter at least one of the variables upon which the demand for that good,
36
3.10. Macroeconomic determinants of money demand
Figure 3.3:
service or asset depends. For example, assume that the demand for apples depends
primarily on the following:
1. their price
2. the price of pears
3. the incomes of consumers, and
4. the tastes and preferences of consumers.

Then a change in the supply of apples will be expected to alter one of these factors
influencing demand. In this case most probably the price of apples. In a similar fashion,
changes in the supply of money can be expected to bring about a change in the value of
one or more of the determinants of the demand for money. The possibility that these
determinants may include interest rates, real income and the general level of prices –
themselves important macroeconomic variables – gives the study of the demand for
money a particular importance.
A particular aggregate money demand function takes the form:
M d = f (Y, Ri , W ). (3.10)
M d is the demand for nominal money balances, Y is nominal income and Ri is the rate
of return on asset i. Since the rate of return on a number of assets will determine the
demand for money, including that on money itself, i can represent a number of assets.
The Ri s represent the opportunity cost of holding money and Y acts as a proxy for the
level of transactions undertaken. Wealth (W ) is included as it forms the budget
constraint on which the choice of money holdings depends but since wealth is
capitalised current and future income, it is not independent of Y . For this reason, and
37
also because data on wealth levels of nations are very difficult to obtain, W is often
dropped from the analysis. If money demand is homogenous of degree one in prices (i.e.
a doubling of the price level leads to a doubling of the demand for nominal money
balances), (3.10) can be re-written as:
d
M
= g(y, Ri ) (3.11)
P
where y is real income. A common log linear form of this equation is:
mt − pt = ayt − bRt (3.12)
where mt , pt and yt are log values of the nominal money supply, price level and income
at time t respectively and Rt is ‘the’ nominal interest rate at time t. Two important
parameters of the money demand function are the elasticities with respect to income
and the interest rate. For a summary of the empirical evidence on these estimates, see
Lewis and Mizen, especially Chapter 11. This chapter also explains in detail the
methods used to estimate such money demand functions.5 The interest elasticity of
money demand is important in the debate over whether monetary or fiscal policy is
more powerful. A low value of b implies a relatively steep LM curve and, other things
being equal, monetary policy has a larger effect on output than fiscal policy. Keynesians
on the other hand argue the opposite: a high value of b and therefore a relatively
shallow LM curve, implying a greater role for fiscal policy.
Of equal importance is whether or not the money demand equation is stable. If the
monetary authorities decide to target the money supply then an unstable money
demand function can lead to unexpected and adverse changes in nominal and possibly
real factors in the economy. The stability of money demand can only be determined by
statistical analysis of the relevant data – hence the enormous number of empirical
studies relating to the demand for money.
3.11 The stability of the money demand function

Relatively simple functional forms of money demand were estimated until the early
1970s and these appeared to work reasonably well at explaining the demand for money.
One such specification was used by Goldfeld (1973) and is similar to (3.12).

M M
ln = b0 + b1 yt + b2 Rt + b3 ln + ut (3.13)
P t P t−1
where ut is a random error term and a lagged dependent variable, ln(M/P )t−1 , is also
included. Goldfeld himself suggested:
‘Perhaps most interesting is the apparent sturdiness of a quite conventional

formulation of the money demand function, however scrutinised. . . (T)he
conventional equation exhibits no marked instabilities, in either the short run
or the long run.’6
5
For a more technical review, see also Goldfeld and Sichel listed in the ‘Further reading’ section.
6
Goldfeld, 1973, quoted by Goodhart, 1989.
38
3.12. Reasons for the breakdown of the money demand functions
However, from 1974 Goldfeld’s equation overpredicted real money balances, M1, in the
US. This was known as ‘the case of the missing money’ (Goldfeld, 1976). Basically, for
any given level of real income and interest rates, the above equation suggested that there
should be more money in circulation than there actually was.7 Such demand for money
functions were breaking down, not only in the US but also elsewhere, such as the UK –
see Hacche (1974) who examined a broader measure of money, M3. Whereas Goldfeld’s
equation overpredicted the amount of money in the US, money demand equations for
the broader M3 aggregate in the UK were underpredicting the amount of money.
3.12 Reasons for the breakdown of the money

demand functions
A common reason quoted for why the money demand equations broke down in the 1970s
was greater financial innovation. The oil shocks of the mid-1970s and the resulting high
inflation caused interest rates to increase substantially. This meant that the opportunity
cost of holding money increased and was eventually so large that it became worthwhile
for cash managers to find more efficient ways of holding cash balances, allowing more
wealth to be put into interest-earning assets. Hence for any level of income and interest
rate, the demand for money would be reduced, explaining the ‘missing money.’
Another possible explanation for the negative results of the 1970s is the fact that a
single equation money demand function may be misspecified. An equation relating real
money balances, income and interest rates may not represent a true money demand
equation, but a reduced form equation; a mixture of both money demand and supply
equations, especially if the money supply set by the authorities is dependent on
conditions in the economy such as inflation and output. A changing policy stance by the
authorities, as was the case from 1979 to 1982 in the US,8 will cause the reduced form
relationship to alter, explaining the breakdown of the estimated ‘demand’ function.
Overly simplified econometrics was also used up until the last couple of decades. Issues
including stationarity, spurious regressions and co-integration need to be addressed
before any meaningful interpretation can be taken from empirical results. See Lewis and
Mizen (2000), Chapter 11.

explain why it is important to study the demand for money
describe the four main microeconomic determinants of money demand
outline the inventory theoretic model of Baumol–Tobin and the portfolio selection
model of Tobin
7
For a review of the stability of the demand for money function, see Judd and Scadding (1982).
8
See Goodhart (1989), Chapter 10.
39
discuss why Tobin’s model solves the ‘plunger’ problem of the demand for money
model of Keynes
describe the general set-up of macroeconomic money demand equations
discuss empirical evidence on money demand functions, especially on the income

and interest elasticities
describe what happened and what is meant by ‘the case of the missing money’ and
give reasons for the breakdown of the estimated money demand equations.

Section A
1. ‘Tobin’s portfolio model implies that the demand for money will always fall when
the interest rate rises.’
Section B
2. According to some economists, Tobin’s portfolio selection model suffers from the
following deficiencies: (a) it explains the allocation of wealth between assets, but it
does not explain the demand for money; (b) it implies that investors view
investment in long-term assets as more risky than investment in short-term assets:
this, however, is false. Discuss these shortcomings.
3. Somebody suggested that instead of introducing the Euro, the European Central
Bank should have introduced a debit card that could be used for any kind of
transaction; a ‘Eurocard’. If this suggestion had been followed by the ECB, what
would be the transaction demand for cash in the euro-area economy?
4. At the micro-level, the transactions elasticity of money demand has been found to
be close to unity and the interest elasticity has been found to be close to zero. How
do these estimates compare to those of the Baumol–Tobin model? Explain why
they differ.
5. By definition, wealth forms the budget constraint that people face when deciding
how much money to hold. Why then is wealth not present in many macroeconomic
money demand functions?
6. Many economists have produced empirical, econometric studies purporting to have

established a stable money demand function, which subsequently broke down.
What went wrong?
40
3.15. Feedback to Activity 3.1
3.15 Feedback to Activity 3.1

If 80% of the taxi driver’s income is spent, that implies non-spent income increases
gradually from zero at the start of the year to £3,000 at the end of the year. As in the
example, the problem amounts to minimising the costs of holding inventory associated
with making transfers, buying and selling bonds, and the opportunity cost of not
holding the higher interest-earning asset. This time, however, the problem involves
choosing the number of times to make transfers. The time profile of deposits and bonds
for an arbitrary number of transfers, n, is shown in Figure 3.2.
With n transfers in the year, the amount transferred each time from money/deposits to
bonds is 3000/n and so the average deposit balance, M , is 3000/2n. Average bond
holdings, B, is then the difference between average non-spent income, £1,500, and M :
3000
B = 1500 − .
2n
The problem then is to maximise profits, i.e.:

3000 3000
max 0.07 1500 − + 0.04 − 5n.
n 2n 2n
The first term is the interest earned on bonds (7% = 0.07) multiplied by average bond
holdings. The second term is the interest earned on deposits, 4%, multiplied by the
average deposit balance, and the last term is the cost per transfer, £5, times the
number of transfers. Simplifying the expression leads to:
45
max 105 − − 5n.
n n
Differentiating with respect to n and setting equal to zero gives an optimal number of
transfers, n, equal to 3, and the average deposit balance, M , is given by:
3000
M= = 500.
2n

Section A
1. The statement is false. Suggested answers may include Figure 3.3 and will explain
what happens after an increase in the interest rate, namely an anticlockwise
movement of the budget constraint. The new point of tangency can lie either to the
left or right of point E, in which case the share of wealth held in money can be
higher or lower than before. This is due to the offsetting income and substitution
effects (to be shown in the diagram).
Section B
2. The suggested answer should show the cost minimisation problem in the
Baumol–Tobin model and also show that the average money demand, M , is given
41
as in (3.3). The elasticities of money demand, with respect to T and i, denoted MT

and Mi , respectively, are given by
∂M T ∂M i
MT = · and Mi = ·
∂T M ∂i M
r
1 1/2 b T 1
MT = ·T · =
2 2i M 2
and Mi can be shown to equal −1/2. The Baumol–Tobin model therefore suggests
transactions and interest elasticities of money demand to be 1/2 and −1/2
respectively. These are different to the empirical estimates of 1 and 0. The main
reason for the difference is that many people cannot afford to enter the bond
markets due to the large brokerage fees. When income increases, agents increase
their money holdings one-for-one. If the interest rate increases, agents do not
convert any wealth to bonds since the high brokerage fees outweigh the benefit of
higher interest received on bonds.
42
Chapter 4
The supply of money
4.1 Introduction
In Chapter 2 we discussed what constitutes money and in Chapter 3 we analysed the
factors that determine how much money individuals, and economies as a whole, demand.
In this chapter we will discuss how money, credit money in particular, is created and
what determines the supply of money. As we shall see in later chapters, the supply of
money is hugely important since a change in the money supply can lead to changes in
the price level and inflation but also to changes in real variables such as output and
unemployment. By affecting the money supply, the monetary authorities can ‘control’
or at least help limit the fluctuations of these variables. Later in this chapter we will see
how the authorities can implement monetary policy to help control the money supply.
4.2 Aims
The aim of the chapter is to study the money supply as one of the building blocks of
the money market equilibrium, the role of financial intermediaries in the credit supply
process and how monetary policy makers can control money supply.

describe and discuss the different roles of financial intermediaries
describe why maturity transformation is so important in financial markets
define on which side of a bank’s balance sheet deposits and loans appear and
explain why the balance sheet must indeed balance
explain how the monetary authorities can influence the total money supply by
changing the monetary base or by introducing mandatory reserve ratios or other
regulation.
43
4. The supply of money
4.4 Reading advice

Any monetary economics textbook will have a section on the supply of money but the
book followed most closely in this chapter is Goodhart (1989). Chapter 5 covers the role
of and need for financial intermediaries and Chapter 6 covers the ideas of the money
multiplier and high-powered money. Unfortunately there is no good reference for the
model of the banking sector at the end of the chapter so you are advised to work
carefully through this section and through the Activities.1

Artis, M.J. and M.K. Lewis Money in Britain: Monetary policy, innovation and Europe.
(New York; London: Philip Allan, 1991).
Chapters 5, 6 and 10.
4.6 Further reading

Books
Brunner, K. ‘High-powered money and the monetary base’, in Newman, P., M. Milgate
and J. Eatwell (eds) The New Palgrave Dictionary of Money and Finance. (London:
Macmillan, 1994).
Goodhart, C.A.E. ‘The monetary base’, in Newman, P., M. Milgate and J. Eatwell (eds)
The New Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994).
Laidler, D.E.W. Taking money seriously and other essays. (New York; London: Philip
Allan, 1990) Chapters 4 and 5.
Macmillan, 1989).
Papademos, L. and F. Modigliani ‘The supply of money and the control of nominal
income’, in Friedman, B. and F. Hahn (eds) Handbook of monetary economics.
(Amsterdam: North-Holland, 1990).
Journal articles
Goodhart, C.A.E. ‘What should Central Banks do? What should be their
macroeconomic objectives and operations?’, Economic Journal 104(427) 1994,
pp.1424–36.
1
The survey article of Papademos and Modigliani is good but difficult. You should, however, be able
to read and understand the basics of Section 3 of this article.
44
4.7. Financial intermediaries
4.7 Financial intermediaries

Financial intermediaries, such as banks, are hugely important in activities such as the
financing of investment projects and in the safekeeping of savings. At any point in time,
there are agents who spend less than they earn, and so wish to save, and there are
agents who spend more than they earn, and so need to borrow. The main service that a
bank provides is the collection of funds from those who wish to save and the lending out
of funds to those who wish to borrow. The reward for providing such services comes
from the difference between the rate of interest paid on savings and that charged on
loans. By charging a higher rate of interest rate on the funds they lend to firms and
households than on the funds they accept from depositors, banks can make profits. This
is also called credit spreads.
If there are agents who want to save and others who want to borrow, why do those with
funds to spare not just lend directly to those who want to borrow (i.e. why do we need
a bank or financial institution at all)? There are a number of reasons to explain the
existence of financial intermediaries, which include:
1. Economies of scale in transactions and information. In order to have a

sufficiently diversified portfolio, agents with funds to save should hold a large
number of different assets. If each agent only had limited funds available, this could
only be done by ‘clubbing’ together. This is exactly the type of service unit trusts
and pension funds provide. Also, if an agent wanted to borrow a large sum of
money, to buy a house or factory for example, it is unlikely that they would find a
single other agent willing to lend such a large sum. If a large number of agents
deposited small quantities of savings at a bank, the bank could then lend a large
amount to a single borrower. The financial intermediary may also be able to obtain
better information about the creditworthiness of a prospective borrower than an
individual agent can; and the intermediary may be more likely to retrieve assets
from a borrower who defaulted on the loan after being made redundant.
2. Insurance. Agents are, in general, risk-averse. If there are two states of the world,
one where an agent received a high income and another where (s)he received a low
income, the average of the utilities from both high and low incomes will be less
than the utility of the average income. As such, the agent would be willing to pay a
fraction of their income in order to smooth their income receipts and hence their
consumption. This is exactly the service insurance firms provide. In a similar
fashion, banks provide insurance services by guaranteeing a rate of return to
depositors even if loans made to borrowers turn bad. Without the bank, the default
risk would be faced entirely by the individual/depositor. By paying the bank,
depositors accept a lower deposit rate than that they have to pay on loans,
depositors can protect themselves from the default risk and obtain a higher utility.2
3. Maturity transformation. Arguably the most important service provided by

banks is that of issuing one form of debt that is illiquid (of long maturity), while
taking on another which is of short maturity. Individual lenders generally want to
lend (to the bank) while still having quick access to their money, in order to make
transactions or for precautionary motives. The liabilities of the bank (the deposits
2
Unless, however, the bank fails as a result of too many borrowers defaulting, for example!
45
of savers) are then liquid and the bank will promise to convert the depositors’
assets on demand. The banks assets, on the other hand, will tend to be illiquid
since private borrowers tend to want to hold long maturity liabilities (the
loans/assets of the bank). For example, if a firm wanted to borrow money to build
a factory, they would want to borrow long term. This would allow the steady
income earned from the investment to gradually pay off the loan.
Activity 4.1 If you had $1,000 in cash and you deposited this at a bank, on what
side of the bank’s balance sheet would this appear? On what side of your own
balance sheet would it appear? What could and should the bank do with this cash?
Since banks hold short maturity liabilities, which they promise to pay to the depositors
on demand, and hold long maturity assets in the form of loans to borrowers, a
paramount concern of banks is therefore to ensure that they can honour demands for
withdrawals by customers. To do this they must always hold an adequate supply of
liquid assets. The problem is that the most profitable assets of a bank are those that
possess least liquidity. Indeed, if the banks held only the most liquid assets in their
portfolios they would not even cover their operating costs! The highest profits are
earned on long-term loans and investments but these are comparatively illiquid assets in
a bank’s balance sheet. Banks are therefore obliged to balance liquidity on the one hand
against profitability on the other.
Activity 4.2 Why are liquidity and profitability sometimes referred to as

conflicting objectives?
4.8 The money multiplier and base money

Base money, also known as high-powered money is the monetary liabilities of the
Central Bank. This consists of notes and coins, and the deposits and reserves of banks
with the Central Bank. If the monetary authorities increased the monetary base by
printing money and giving it to private individuals, those individuals will, more likely
than not, deposit a fraction of it with their bank. The bank will not want to keep all of
these deposits in the form of liquid assets, as this strategy will not earn the bank the
most money. Remember that liquid assets earn the lowest interest. Instead it will keep a
fraction of it in liquid form but lend out the rest in order to earn a higher return. The
funds given out as loans will be spent and subsequently deposited at the bank of
whoever sold the goods to the initial borrower. Again the bank will lend out a fraction
of these new deposits and the process continues. In equilibrium the total increase in the
money stock, the liabilities of the government (notes and coins) and the liabilities of
banks (deposits) will be a multiple of the increase in the high-powered money. This
multiple will depend on the fraction of the money individuals wish to deposit with their
bank, the currency-deposit ratio, and the fraction of the deposits the bank wishes to
keep in cash reserves and not lend out, the reserve-deposit ratio. If these ratios are
stable through time then by controlling the base money, the monetary authorities can
control the total money supply in the economy.3 Let the total money supply in the
3
Controlling the money supply is not as simple as it sounds, however. See Goodhart (1989).
46
4.9. A simple model of the banking sector
economy, M , be made up of deposits, D, and the liabilities of the government, notes

and coins, C. Therefore:
M = D + C. (4.1)
Also, let high-powered money, H, be made up of the notes and coins in the general
public, C, and the remainder of the government’s liabilities held by banks in the form of
reserves, R:
H = C + R. (4.2)
Dividing (4.1) and (4.2) by D and then dividing one by the other, we can write:

1 + (C/D)
M =H . (4.3)
(C/D) + (R/D)
The bracketed term is the money multiplier: the factor which, when multiplied by the
base money, gives the total money supply in the economy. As can be seen, it is a
function of the currency-deposit ratio (C/D), and the reserve-deposit ratio (R/D). The
monetary authorities should be able to directly control the stock of high-powered
money, H, but the determination of the total stock of money, M , ultimately depends on
the banking sector and the preferences of private individuals. It is the workings of the
banking sector to which we now turn.
4.9 A simple model of the banking sector

Assume a banking industry whose market is described by:
D = d0 − d1 (i − iD ) (4.4)
L = d0 + l1 (i − iL ) (4.5)
where L is the (demand for) bank loans, D is the (supply of) bank deposits, iL the rate
charged on loans, iD the interest paid on deposits and i the ‘market’ interest rate. Note
that the supply of deposits is a positive function of the interest rate paid on deposits
and a negative function of the market interest rate – the interest rate one could earn
elsewhere. If iD was large relative to i, that would encourage individuals to deposit
more funds with the bank. Equivalently, the demand for loans is a negative function of
the interest rate charged on loans. If the interest rate you had to pay on a loan was high
relative to the market rate, you would borrow, not from the bank, but from elsewhere.
Assume the banks have no operating costs and have no other assets or liabilities.
Finally, d0 captures an arbitrary banking relationship constant. It represents the
minimum an individual would deposit to the bank and the minimum a firm receives
from the bank to hold a bank relationship.
Competitive equilibrium
The profits made by the bank will equal the quantity of loans, L, multiplied by the
interest earned on those loans, iL (which is the bank’s revenues)4 minus the costs faced
4
Assume there are no borrowers defaulting on their debts.
47
by the bank. Costs will equal the interest paid to depositors in order to encourage them
to hand over their funds to the bank. Costs then equal the quantity of deposits, D,
times the interest rate paid on deposits, iD . Denoting bank profits by Π and noting that
in a competitive equilibrium, profits equal zero:
Π = L · iL − D · iD (4.6)
Π = 0 (competitive equilibrium). (4.7)
When making the additional assumption that the bank holds no reserves, in order for
the bank’s balance sheet to balance, loans (assets) must equal deposits (liabilities),
L = D. Substituting into (4.6) and using (4.7) implies that in equilibrium:
iD = iL . (4.8)
Substituting into (4.5) and equating L with D gives:
d0 − d1 (i − iD ) = d0 + l1 (i − iL ). (4.9)
Solving for the interest rate on deposits, which equals the interest rate charged on loans
from (4.8), gives:
iD = iL = i. (4.10)
This implies total deposits, D, which equals total loans, L, equals d0 from either (4.4)
or (4.5). This is shown in Figure 4.1 below.
In equilibrium, the interest rate paid on deposits equals the interest rate charged on
loans, which equals the market interest rate, i. The level of deposits, which in this
model is equal to the level of the money stock, equals the amount of loans.
Figure 4.1:
48
Government regulation of the deposit rate
One way that the government could reduce or control the money supply is by setting a
limit on the interest rate paid on deposits. If the maximum interest rate banks can pay
on deposits is less than i in the above example, then the amount of funds savers are
willing to deposit with the bank will fall, resulting in a lower money supply. Note that
this will also be associated with a lower quantity of loans that, despite the lower money
supply, may be harmful to the economy if it means some investment opportunities are
not undertaken.
Consider the case where the government sets the interest rate on deposits equal to zero.
From (4.4), the quantity of deposits is fixed at D = d0 − d1 i. Diagrammatically, this is
shown in Figure 4.2.
Figure 4.2:
The level of deposits, and hence of the money supply, has fallen from d0 to d0 − d1 i
because of the government regulation. Since deposits must equal loans in order for the
bank’s balance sheet to balance, the lower level of deposits means a lower level of loans,
which is associated with a higher interest rate charged, iL > i. Also, since there is a
difference between the interest rate charged on loans and that paid on deposits (which
has been set at zero), the government regulation has allowed the banks to make positive
profits.
Activity 4.3
1. By equating deposits with loans, and noting that iD = 0, find an expression for
iL in terms of the market interest rate, i.
2. Using (4.6) find an expression for the profits made by the banks in terms of the
market interest rate.
49
Reserves
As discussed above, banks will try to keep a fraction of their assets in liquid form in
order to meet the day-to-day needs of depositors who withdraw their funds. Assume
that the government introduces a mandatory reserve ratio, r∗ (i.e. total reserves of the
bank, R, equals r∗ × D). The bank’s assets now comprise loans, as before, but now
include these reserves. Its liabilities are just the deposits of its customers.
Assets = Liabilities
⇒ r∗ · D + L = D
⇒ L = (1 − r∗ )D. (4.11)
Substituting (4.11) into the zero profit condition, (4.6) and (4.7), and rearranging will
give the interest rate charged on loans to be:
iD
iL = > iD . (4.12)
1 − r∗
The interest rate charged on loans is now higher than the interest rate paid on deposits.
This is in order to compensate the banks for holding reserves, on which it earns no
interest. Total loans are now less than total deposits so each dollar lent out must earn a
higher return than that paid on each dollar deposited with the bank. iL then needs to
be greater than iD .
Activity 4.4 Substitute out L and D from (4.4) and (4.5) into (4.11). Then
substituting out iL from (4.12), show that the rate of interest paid on deposits is
equal to:
l1 r∗ r∗ (1 − r∗ )d0

iD = 1 − i + . (4.13)
l1 + d1 (1 − r∗ )2 l1 + d1 (1 − r∗ )2
Substitute this out into the supply of deposits equation, (4.4), and show that total
deposits are given by:
l1 + d1 (1 − r∗ ) d1 l1 r∗
D= d 0 − i. (4.14)
l1 + d1 (1 − r∗ )2 l1 + d1 (1 − r∗ )2
Although (4.13) and (4.14) appear complicated, they simply relate the deposit rate and
total deposits (money supply) to the market interest rate and to the reserve ratio. By
changing the mandatory reserve ratio, the government can change the total money
supply through the activities of the banking sector. However, the way in which D varies
with r∗ is uncertain and depends on the parameters of the model. With no reserve
requirements we equate L to D in order for the bank’s balance sheet to balance. In this
situation we equate L to (1 − r∗ )D from (4.11). Therefore the new intersection results
in a lower value of L but a higher interest rate charged, iL . Total revenues for the bank,
L × iL , could then increase or decrease depending on the elasticity of the demand for
loans function.
50
If the demand for loans is elastic then, if L falls, revenue will fall. Banks will be forced
to cut the interest paid on deposits, so iD falls, resulting in fewer deposits and hence
causing the money supply to fall.
If the demand for loans is inelastic, a fall in L, caused by the reserve ratio, will increase
revenues. The banks will increase iD and so total deposits will increase.
Monetary base control
As seen above, the government can control the money supply by directly controlling the
rate of interest paid on deposits and it can also affect it through imposing a mandatory
reserve ratio. However, by forcing the banks to hold a certain level of reserves, not just a
reserve ratio, it can directly control the monetary base. Note that high-powered money
equals reserves plus cash held by the general public (see (4.2)) and the government
directly controls the amount of cash in the economy since it is the monopoly supplier.
The government fixes the amount of bank reserves, R, at R∗ . Together with the reserve
ratio, r∗ , this explicitly determines the amount of deposits in the economy since
R∗ = r∗ D. Inverting (4.14) will give an expression for the market interest rate in terms
of r∗ and R∗ .
l1 + d1 (1 − r∗ ) l1 + d1 (1 − r∗ )2
i= d 0 − D (4.15)
d1 l1 r∗ d1 l1 r∗
where:
R∗
D= . (4.16)
r∗
This is shown in Figure 4.3.
Figure 4.3:
51
The level of total deposits, and hence the supply of money, is determined by the
mandatory requirement that the banks hold a fixed level of reserves, R∗ , and have a
fixed reserve ratio, r∗ . Changing R∗ will directly affect the money supply, shifting the
vertical D = R∗ /r∗ schedule left or right. However, doing so will necessitate a change in
the market interest rate in order to achieve equilibrium in the banking sector.
Activity 4.5 Assume an economy in which the demand for bank loans is given by:
L = 1000 + 25(i − iL )
and in which the portfolio preferences of the public generate a supply of bank
deposits given by:
D = 1000 − 50(i − iD )
where iL is the interest rate charged on bank loans, iD the interest rate paid on bank
deposits and i the ‘market’ interest rate (and interest rates are measured in
percentage points so that a rate of two per cent is given as 2, not 0.02).
The banks hold no reserves and have no other assets and liabilities and incur
operating costs of £60 a year for every £1,000 of deposits.
1. Assuming the banking system is competitive, solve for the loan rate and the
deposit rate as functions of the market interest rate and determine the stock of
money in equilibrium.
2. Imagine that the banks were now to collude and reach an agreement to set loan
and deposit rates which maximise the profits of the industry. What loan and
deposit rates will they set, what will be the profits of the industry and what will
be the effects of this cartel on the stock of money?
3. Assume the banking industry is described as in the first part of the question
(i.e. competitive and unregulated). The government can influence the ‘market’
interest rate through its dealings in the gilt-edged money markets. What is the
effect of a change in the market interest rate on deposit and loan rates and on
the stock of money? Explain. Is monetary policy impotent in this economy?
(For Feedback, see the end of this chapter.)

describe and discuss the different roles of financial intermediaries
describe why maturity transformation is so important in financial markets
define on which side of a bank’s balance sheet deposits and loans appear and
explain why the balance sheet must indeed balance
52
explain how the monetary authorities can control the total money supply by
changing the monetary base or by introducing mandatory reserve ratios or other
regulation.

Section A
1. ‘From the money multiplier analysis, the stock of money is a multiple of the
quantity of high-powered money. Since this is set by the monetary authorities, the
authorities can directly set the quantity of money in the economy.’
Section B
2. Why should banks be required to satisfy restrictions placed by the regulatory

authorities in the form of required reserve ratios?
3. Do banks perform a role in the financial system that is qualitatively different from
the role of other ‘non-bank’ financial intermediaries (NBFIs)? Should all financial
institutions be regulated by the authorities in the same way?
4. It is sometimes argued that regulation of the banking system (by minimum reserve
requirements, for example) acts like a tax on banks, and leads to the growth of
non-bank financial intermediation, which escapes the regulation. Therefore, it is
argued that bank regulation is self-defeating and undesirable. Discuss.
5. What is the effect of an increase in the ‘market’ interest rate on the equilibrium
value of bank deposits (and hence on the money stock) on the assumptions that:
(a) the banking system is competitive and unregulated, but the banks require for
commercial reasons to hold some proportion of their deposits in the form of
cash
(b) the banking system is regulated by a rule preventing banks from paying
interest on deposits?
Is the effect bigger under assumption (a) or (b)? Explain.

1. With no reserves, it must be the case that loans equal deposits, as in the first part
of the example in Chapter 3 ((4.4) onwards). The profits of the bank are given by
revenues, L × iL , minus costs. Costs include the interest on deposits, D × iD , but
53
also the operating costs of £60 per £1,000 deposited, i.e. 6% of deposits. Profits, Π,
are then given by:
Π = L · iL − D · iD − 6D (4.17)
Π = 0. (4.18)
Noting that L = D, the zero profit condition can be solved to give:
iL = iD + 6. (4.19)
Substituting (4.19) into the loan demand equation and equating this to the supply
of deposits equation gives:
1000 + 25(i − (iD + 6)) = 1000 − 50(i − iD ). (4.20)
Solving for iD gives:

iD = i − 2 (4.21)
which implies:
iL = i + 4. (4.22)
From either the loan demand or supply of deposits equation, we find that the stock
of money in equilibrium is:
D = L = 1000 + 25(i − (i + 4)) = 900. (4.23)
This is shown in Figure 4.4.
2. Equating loans with deposits gives a relationship between iL and iD of:
iL = 3i − 2iD . (4.24)
Using (4.24) and the loan demand and supply of deposits equations we can use
(4.17) to obtain an expression for profits.
Π = (1000 − 50(i − iD ))(3i − 2iD − iD − 6). (4.25)
Differentiating this with respect to iD , the bank’s choice variable, results in an

optimal deposit rate of:
iD = i − 11. (4.26)
Using (4.24) and the supply of deposits equation, this results in:
iL = i + 22 (4.27)
D = 1000 − 50(i − (i − 11)) = 450. (4.28)
3. From ‘1.’, D = 900 (i.e. deposits are a constant in equilibrium and are not a
function of the market interest rate). Changing i will not change D and hence will
not change the stock of money. The government bids for funds by increasing i so
banks have to compete by increasing their own rates. In total, nothing happens to
54
4.13. Feedback to Sample examination questions
D or L since they both only depend on interest differentials. From (4.21) and
(4.22), diL /di = diD /di = 1. The effect of changing the market interest rate is
shown in Figure 4.4 below.
Even though the money stock has not changed, an increase in the nominal interest rate
will increase the real interest rate if prices (inflation) do not change. Therefore,
investment and consumption will be affected (reduced) and so monetary policy may not
be impotent.
Figure 4.4:

Section A
1. The statement is uncertain. The suggested answer should show the relationships
between M (money stock) and H (high-powered money) from (4.1) to (4.3). The
money multiplier will be shown to be a function of two ratios (currency-deposit and
reserve-deposit). Only if these ratios are stable will the monetary authorities be
able to control the stock of money directly.
Section B
5. For the first part, where the banking system is competitive and unregulated, the
effects of an increase in the market rate of interest will be to increase deposit and
loan rates one-for-one but to leave the money stock unaffected. See the outline
answer to ‘3.’ of Activity 4.5.
In (b), where banks do not pay interest on deposits, consider Figure 4.2 and (4.4).
Deposits are fixed at D = d0 − d1 i and therefore an increase in the market rate will
55
cause the money stock to fall. It is therefore likely that the effect of the increase in
market rates is greater in the second case. The money stock falls and the increase
in the market rate can have real effects, as described above.
56
Chapter 5
Classical theory
5.1 Introduction
The classical model is hugely important for the analysis of monetary theory. If one
commodity has been introduced into the economy to serve the functions of money and
has no other use or value, what determines the value of such a commodity, or the prices
of other goods and services in relation to that money commodity? These are essentially
the questions we will be answering in this chapter. We will analyse the general
equilibrium framework of Walras and use it to explain what is meant by the ‘Classical
dichotomy’, namely the separation of the real side of the economy from the monetary
side. Finally, we will give an explicit example of Walras’ law by introducing money in a
general equilibrium framework; a set-up we will use extensively in later chapters.
5.2 Aims
In this chapter we aim to study a general equilibrium environment with money.

define and explain the term ‘neutrality of money’
describe the essential features and predictions of the quantity theory of money
describe the main features of the classical system and the classical dichotomy
discuss the implications of Walras’ law in the determination of general equilibrium
state the nature and importance of Patinkin’s real balance effect for the internal
consistency of the classical dichotomy.
5.4 Reading advice

You are recommended to read the appropriate chapters or sections in one or more of the
basic monetary economics textbooks before tackling the material presented here. All
will discuss, to greater or lesser extents, classical theory and issues surrounding
57
5. Classical theory
monetary neutrality. The book followed most closely here is Lewis and Mizen, Chapters
3 and 4, but see also Harris, Chapters 4 and 5.
You are also strongly advised to read the entries on ‘Neutrality of money’ and ‘Quantity
theory of money’ in The New Palgrave Dictionary of Money and Finance. The latter
chapter is quite long but covers material relevant not only for this, but for other
chapters in the guide.

Friedman, M. ‘The quantity theory of money’, in Newman, P., M. Milgate and J.
Eatwell (eds) The New Palgrave Dictionary of Money and Finance. (London:
Macmillan, 1994).
Harris, L. Monetary Theory. (New York; London: McGraw-Hill, 1985) Chapters 4 and 5.
University Press, 2000) Chapters 3 and 4.
Patinkin, D., ‘Neutrality of money’, in Newman, P., M. Milgate and J. Eatwell (eds)
The New Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994).
5.6 Further reading

Cagan, P. ‘Monetarism’, in Newman, P., M. Milgate and J. Eatwell (eds) The New
Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994).
Laidler, D. ‘The quantity theory is always and everywhere controversial – why?’,
Economic Record 67(199) 1991, p.289.
Patinkin, D. Money, interest and prices: an integration of monetary and value theory.
(New York: Harper and Row, 1965).
5.7 The quantity theory of money

The value of money can be established through the well-known ‘equation of exchange’,
which is at the centre of the classical quantity theory of money. The equation of
exchange,
MV ≡ P T (5.1)
is an identity since the two sides of the equation are simply different ways of measuring
the same thing, namely the total value of all monetary transactions in the economy. M
is the stock of money, the number of units of the money commodity, V is the velocity of
circulation, the number of times each unit of money is used in transactions per period,
T is the number of transactions in a period and P is the average monetary value of each
transaction.1 Essentially, the value of the money paid out, M V , must be equal to the
value of goods and services it buys, P T .
1
Note that the ‘stock’ of any variable refers to the total accumulated value of a variable over years,
whereas ‘flow’ refers to a change in the variable within a given time period.
58
5.7. The quantity theory of money
The quantity theory determines the price level on the basis of the assumptions made
about the variables in the equation. V is taken as exogenous, being determined by
various institutional features of the economy, such as the frequency with which workers
get paid. T , the number of transactions, is determined by real variables such as
preferences, endowments and technology, and M is, in a fiat money economy,
determined by the government.2 On these assumptions the price level, P , is
proportional to the stock of money, M , in the sense that changes in the stock of money
lead to equi-proportional changes in the price level. Taking logs of (5.1) gives:
ln Mt + ln Vt = ln Pt + ln Tt (5.2)
where we have introduced a time subscript to all variables. Differentiating this with
respect to time gives:
1 dMt 1 dVt 1 dPt 1 dTt
· + · ≡ · + · . (5.3)
Mt dt Vt dt Pt dt Tt dt
If velocity and transactions are considered exogenous, meaning these are not changing
through time, then their derivatives with respect to time are simply zero. For the
remaining terms, noting that (1/Xt ) · (dXt /dt) is simply the growth rate of Xt , then
(5.3) implies that the growth rate of the money supply is equal to the growth rate of
the price level (i.e. inflation). In this sense, inflation cannot occur without a
commensurate increase in the supply of money.
The Cambridge view of the quantity theory
Whereas the equation of exchange is a flow equation, relating the number of

transactions made per period to the flow of money per period handed over to facilitate
these transactions, the Cambridge school, under Marshall, transformed it to a stock
equation. As such, the Cambridge school transformed the quantity theory to a demand
function of the form:3
M = kP Y. (5.4)
In its simplest form, velocity was assumed constant, in which case k = 1/V and the
amount of money one held was equal to a proportion of the number of transactions, or
alternatively, income, Y .
The velocity of money
The velocity of money measures how many times a unit of money is used to purchase
goods and services per period. It is also a measure of the stability of the money
demand. Consider now a situation where the velocity of money doubles (i.e. every
individual spends their money twice as fast as before). What is the implication of this
on the equation of exchange? Assume initially that Joanna gets paid £800 a month and
spends a quarter of this at the beginning of each week. Her money balances are then
£600 during the first week, £400 during the second week, £200 during the third and £0
during the final week of the month when she is waiting to receive her next salary. This
is depicted in Figure 5.1a below.
2
‘Transactions’, T , are often proxied by income, Y , to give a quantity theory of M V = P Y .
3
Notice the similarity between this equation and the macroeconomic money demand equations in
Chapter 2 of the subject guide.
59
5. Classical theory
Figure 5.1:
Joanna’s average money holdings over the month are then:

1 1 1 1
£600 · + £400 · + £200 · + £0 · = £300. (5.5)
4 4 4 4
Now consider the case where Joanna gets paid twice per month, receiving £400 at the
beginning of week 1 and £400 at the beginning of week 3. Again she spends a quarter of
her income in each quarter of the payment period, so that her money balances are £300
in the first half of week 1, £200 in the second half, £100 in the first half of the second
week and zero in the last half of that week. Similarly, for the second half of the month.
Notice that her transactions remain unchanged at £800 per month but the velocity of
money has doubled; any money balance is spent twice as quickly. Her money holdings
are now shown in Figure 5.1b. Joanna’s average money holdings over the month are
therefore given by:

1 1 1 1
£300 · + £200 · + £100 · + £0 · × 2 = £150. (5.6)
8 8 8 8
As a result of the velocity of money doubling, caused by a change in the way people are
paid, the average money holdings over the period have halved from £300 to £150.
Other determinants of the velocity of money include individual habits and spending
patterns, social conditions, the efficiency of the payments system and possibly also the
interest rate. As discussed in Chapter 2, if the interest rate remains high for some time,
this may cause individuals to try to find more efficient ways of holding their wealth in
order to avoid the high opportunity cost of holding money. One consequence of high
interest rates may then be that any money balances are spent more quickly, implying an
increase in velocity.
The classical dichotomy and monetary neutrality
The classical economists assumed that, although money was essential for the efficient
functioning of the economy, the quantity of money units had no impact on real
60
5.7. The quantity theory of money
variables. According to the ‘Classical Dichotomy’ only real variables (preferences,

endowments and technology) determined real outcomes (quantities and relative prices).4
The quantity of money, on the other hand, determined the absolute price level or the
value of goods in terms of monetary units, from the equation of exchange. According to
the classical economists, money was neutral, in the sense that the quantity of it has no
effect on any real variable in the economy. In order to explain these ideas more fully, we
first consider the notions of Say’s law and Walras’ law.
Say’s law and Walras’ law
Say’s law essentially states that supply creates its own demand. In a barter economy in
which there are n − 1 goods, each supplier has an endowment of some good. They each
exchange these goods for those they desire and it is the level of their endowment, that
determines how much they can buy. Supply funds demand. It must therefore be true
that the sum of expenditures over all goods i = 1, . . . , n − 1 must equal the sum of the
supplies of all goods, denoted Si .
n−1
X n−1
X
pi Di ≡ pi S i (5.7)
i=1 i=1
where pi is the relative price of one good in terms of another. Remember we are
considering a barter economy here, which therefore has no monetary prices.
Alternatively, defining the excess demand for good i, EDi , as Di − Si , then:
n−1
X
pi EDi ≡ 0. (5.8)
i=1
In Say’s view, market laws imply that there cannot be a ‘general glut’. If there exists an
excess demand for one good then there must be an excess supply of another. However,
there cannot be a general excess demand or general excess supply at the aggregate level
(in a closed economy). Each household has endowments of one or more goods, and a
utility function defined over all goods, from which we can derive the demand of each
household for each good as a function of relative prices. Adding up the demand for each
good across households, and given the total endowment of that good, we can write
down a market clearing equation for each good as a function of relative prices.
Since all households must balance their budgets, the sum of all market clearing
equations must add up to zero. Therefore in a market for n − 1 goods, if there is
equilibrium in n − 2 goods, there must be equilibrium in the final market. This is
Walras’ law. The n − 1 market clearing equations are not independent; if all markets
except one clear, the last market must clear also. Only n − 2 equations are independent,
but this is sufficient to solve for n − 2 relative prices, for example the prices of all goods
in terms of good 1. To establish the equilibrium of an economy of n − 1 goods we may
solve for n − 2 relative prices and this will in turn determine the demand from each
household for each good.
4
Relative prices being the exchange ratios of one good for another, for example one kilogram of
tomatoes equals two loaves of bread.
61
5. Classical theory
Money in general equilibrium
Now consider a monetary economy (i.e. we introduce fiat money as the n-th good). The
price of this good is pn , usually normalised to unity for simplicity. From Walras’ law:
n
X n
X
pi Di ≡ pi S i (5.9)
i=1 i=1
and separating out good n, money:

n−1
X n−1
X
pi D i + pn D n ≡ pi Si + pn Sn . (5.10)
i=1 i=1
Dn and Sn are the demand and supply of nominal money balances, respectively, and
from Walras’ law we can see that if there is equilibrium in the n − 1 goods markets then
there must be equilibrium in the money market. However, Say’s law may not hold.
There can exist a general excess supply in the n − 1 goods markets; (5.7) may not hold,
but only if this is offset by excess demand in the money market. The demand for good i
will depend on all relative prices and income, implying excess demand for good i, EDi ,
of:5
P1 P 2 Pn−1
EDi = fi , ,..., , Y − Si∗ (5.11)
Pn P n Pn
where Y is the total output. However, the absolute price level, the price of money, pn ,
will have no effect on excess demand. If the price of money, pn , doubles, caused by a
doubling of the money supply from the equation of exchange, since pn is an average of
all other prices, then p1 , . . . , pn−1 must all double also. The relative prices,
p1 /pn , . . . , pn−1 /pn , will not change, resulting in no change in (excess) demands for any
goods. In this way, a changing of the money supply will have no repercussions in the
real economy. Hence money is neutral.
Patinkin and the real balance effect
There were found to be a number of criticisms of the dichotomy the classical economists
had proposed.6 One problem was that the model was internally inconsistent. On the one
hand, the excess demand for each commodity, i = 1, . . . , n − 1, was only dependent on
relative prices, not the absolute price level, pn , and from Walras’ law, the excess
demand for money is then determined. The excess demand for money is then only a
function of relative prices. However, from the quantity theory, which is needed to solve
the entire system of equations, the demand for money explicitly depended on the
absolute price level. On one side, money market equilibrium depends only on relative
prices while on the other side, it depends only on the absolute price level.
An attempt to resolve this problem was made by Patinkin who included the value of
real money balances, Sn /pn , as a determinant of the demand for each good; in other
words the excess demand for each good i is given by:

P1 P2 Pn−1 Sn
EDi = fi , ,..., , Y, − Si∗ . (5.12)
Pn Pn Pn Pn
5
Assume for simplicity that the supply is fixed at Si∗ .
6
See Lewis and Mizen (2000) Chapter 4 for an excellent description of these criticisms.
62
5.8. A simple general equilibrium framework
Real money balances are the ratio between nominal money balances and the price level.
A change in either of these nominal variables will change the value of the real variable
and thereby change the demand for commodities. Thus, starting from a position of
equilibrium in all markets including the money market, assume that there is an increase
in the supply of money. This increases real money balances which in turn increases the
demand for commodities, even though there has been no change in relative prices. But
the increase in demand, having started from a position of equilibrium, must mean that
there is now excess demand, a situation which denies Say’s law. The increased demand
for commodities will then bring about an increase in the general level of prices that will
reduce real balances. Eventually real balances will return to their equilibrium level, as
will the demand for commodities. Real balances provide a bridge between the real and
monetary sectors of the classical system and dispose of the classical dichotomy, that is
factors influencing nominal variables are separated from factors influencing real
variables, while retaining the neutrality of money, that is monetary changes do not
change real variables.
5.8 A simple general equilibrium framework

Whereas in the previous analysis, individuals’ utility was defined over goods, we now
assume it depends also on the level of real money balances. The justification, according
to Patinkin, is that even if households plan to balance their budgets so that planned
purchases are equal in value to planned sales, it may be convenient to buy and sell
goods at different times. The more money they hold, the greater the extent to which
they can purchase goods ahead of making sales. Money holdings stand as a proxy for
the more convenient sequence of transactions they make possible. Thus, money is in the
utility function.
Assume a household’s utility depends on the quantity of goods consumed, X, and on
real money balances, M/P . Let the household have initial endowments X0 of goods and
M0 of nominal money balances. The budget constraint faced by the household is then,
in nominal terms:
P X + M ≤ P X0 + M0 . (5.13)
So that the nominal expenditure on goods, P X, plus the holdings of nominal money
balances, M , must not be greater than the nominal value of the endowments of goods
and money. Writing the budget constraint in real terms (dividing by the price level)
gives:
M M0
X+ ≤ X0 + . (5.14)
P P
The household’s utility function takes the specific form U = X 1/2 (M/P )1/2 . In order to
determine the demands for goods and real money balances, we maximise the utility
function subject to the budget constraint. To do this we form the Lagrangian:7
1/2
1/2 M M0 M
L=X + λ X0 + −X − . (5.15)
P P P
7
We also impose an equality in the budget constraint as this implies no wastage of goods or money.
63
5. Classical theory
Differentiating with respect to the two choice variables, X and M/P , gives the first
order conditions of:
1/2
∂L 1 −1/2 M
= X −λ=0 (5.16)
∂X 2 P
−1/2
∂L 1 1/2 M
= X − λ = 0, (5.17)
∂(M/P ) 2 P
from which we obtain

M
X= (5.18)
P
Substituting into the budget constraint will give solutions for the demands for goods
and nominal money balances of:
X0 + M0 /P P X0 + M0
X= and M = . (5.19)
2 2
Assume now that the economy consists of n households each identical to the one
described above. The market clearing condition in the goods market then becomes:

X0 + M0 /P
n = nX0 . (5.20)
2
In other words, total demand equals total supply. Solving for the price level gives:
M0
P = . (5.21)
X0
Alternatively, we can write down the market clearing condition for the money market:

P X0 + M0
n = nM0 . (5.22)
2
If we solve for the price level here, we obtain:
M0
P = . (5.23)
X0
In this economy, money is neutral. Real output per household is fixed at X0 as it

depends on endowments. From the solution of the price level, a change in the money
supply will only lead to a proportional increase in prices. Real money balances and
‘production’ of goods do not change. An increase in money, M0 , will shift the demand
function for good X outwards in Figure 5.2 but this simply causes the price level to
increase.
Activity 5.1 Why is the solution for the price level the same when we solve for the
goods market equilibrium as for when we solve for the money market equilibrium?
(Hint: Consider Walras’ law and the fact we are considering only two markets: those
for goods and money!)
64
5.9. A reminder of your learning outcomes
Figure 5.2:

define and explain the term ‘neutrality of money’
describe the essential features and predictions of the quantity theory of money
describe the main features of the classical system and the classical dichotomy
discuss the implications of Walras’ law in the determination of general equilibrium
state the nature and importance of Patinkin’s real balance effect for the internal
consistency of the classical dichotomy.

Section A
1. ‘A doubling of the velocity of circulation results in the price level doubling.’
65
5. Classical theory
Section B
2. To what do economists refer by the phrases ‘neutrality of money’ and ‘the classical
dichotomy’ ? What problem did Patinkin have with these ideas and how did he
solve it?
3. Which factors did the Cambridge quantity theorists (A. Marshall, A. Pigou) stress
as significant in explaining the transactions demand for money?
4. ‘A given increase in the stock of money has the same long-run effect on the price
level whether it results from a temporary budget deficit, or from open market
operations, or is dropped from a helicopter.’ Discuss.
5. Walras’ law states that the sum of excess demands in all markets must be zero.
How does this differ from the following statement? If there are n goods, the
markets for n − 1 goods must always be in equilibrium.

Section A
1. The statement is false. Suggested answers will introduce the quantity theory,
M V = P T , explaining that V depends on institutional factors such as the
frequency with which people are paid, spending patterns, etc. You should also show
that a doubling of V results in a halving of M , the demand for money. This could
be done using the example of (5.5) and (5.6).
Section B
2. According to the classical dichotomy, only real variables (preferences, endowments

and technology) determine real outcomes (quantities and relative prices of one good
in terms of another). Money, on the other hand, determines the absolute price level,
or the value of goods in terms of monetary units, from the equation of exchange,
M V = P T . Real variables determine real outcomes, while monetary variables
determine monetary outcomes, hence the dichotomy between real and monetary
sectors. Since the quantity of money has no real effect on the economy, money is
therefore said to be neutral. This is what economists refer to as ‘the neutrality of
money’. The problem that Patinkin had with these ideas was that the system was
not internally consistent. On the one hand, the excess demand for each commodity,
i = 1, . . . , n − 1 was only dependent on relative prices, not the absolute price level,
pn , and from Walras’ law, the excess demand for money is then determined. The
excess demand for money is then only a function of relative prices. However, from
the quantity theory, which is needed to solve the entire system of equations, the
demand for money explicitly depended on the absolute price level. On one side,
money market equilibrium depends only on relative prices while on the other side,
it depends only on the absolute price level. In order to solve the problem, Patinkin
argued that the demand for each good was a function of real money balances. See
the discussion in the section ‘Patinkin and the real balance effect’.
66
5. Walras’ law can be derived from Say’s law, which essentially states that supply
creates its own demand. If the sum of excess demands in all markets must add up
to zero, then if the sum of excess demands in markets 1 to n − 1 are zero, it must
be the case that excess demand in the n-th market is also zero. However, with n
goods, the markets for n − 1 goods can only be in equilibrium if the market for the
n-th good is in equilibrium. If there is positive excess demand in the n-th market,
there must be positive excess supply in the n − 1-th market, implying
disequilibrium in these n − 1 markets.
67
5. Classical theory
68
Chapter 6
Stylised facts
6.1 Introduction
Macro-monetary models aim to explain the macroeconomic phenomena that we observe
in the data. In order to do so we need to have a set of stylised facts that we want to
explain. Bear in mind that a model can only be judged by its usefulness to explain
those stylised facts. Collecting data from statistical agencies and policy institutions
(such as national statistical offices, OECD, IMF/IFS, central banks), about production,
consumption, investment, inflation, employment, unemployment and so on, is the first
step to start analysing those facts we want to evaluate statistically and provide an
internally consistent narrative to explain these facts. However, statistical (time series)
data often need to be adjusted for establishing these stylised facts. In this chapter we
will introduce several concepts of macroeconomics for which we need to look into the
data and adjust these so that they become our statistical benchmarks.
6.2 Aims
This chapter aims to introduce key macroeconomic stylised facts which need to be
explained by theoretical modelling. To this end, some simple statistical tools such as
means, variances, correlations will be utilised.

describe trends versus business cycles
calculate the means, volatility, cyclicality and persistence of business cycle

components of macro-variables
list key business cycle stylised facts
discuss the relevance of monetary aggregates and short-term interest rates as

potential policy instruments.
69
6. Stylised facts
6.4 Reading advice

Facts about macroeconomics are constantly changing with the arrival of new and better
data and the debate about the actual stylised facts are seamlessly going on with the
data and new statistical techniques. For a general discussion on measurement issues
Williamson (2010) is a good starting point. Calderon and Fuertes (2014) provide an
excellent analysis of the recent business cycle stylised facts. For the relevance of
monetary aggregates and short-term interest rates in explaining variations in income
and prices you should read Friedman and Kuttner (1992) and Aksoy and Piskorski
(2006). For an analysis of the evolution of the Phillips curve in a small sample of
countries you should read Kuttner and Robinson (2010).

Aksoy, Y. and T. Piskorski ‘US domestic money, inflation and output’, Journal of
Monetary Economics 53, 2006, pp.183–97.
Calderon, C. and R. Fuertes ‘Have business cycles changed over the last two decades?
An empirical investigation’ Journal of Development Economics 109, July 2014,
pp.98–123.
de Grauwe, P. and Polan, M. (2005) ‘Is inflation always and everywhere a monetary
phenomenon?’ Scandinavian Journal of Economics, 107 (2), 2005, pp.239–59.
Friedman, B. and K. N. Kuttner ‘Money, income, prices and interest rates’, American
Economic Review 82, 1992, pp.472–92.
6.6 Further reading

Books

(Oxford: Oxford University Press, 2006) Chapter 6.
Williamson, S.D. Macroeconomics. (Prentice Hall; fourth edition 2010) Chapters 1,2,3.
Journal articles
Aksoy, Y. and G. Melina ‘US fiscal indicators, inflation and output’, North American
Journal of Economics and Finance 22 2011, pp.221–36.
Alvarez, L. , E. Dhyne , M. Hoeberichts , C. Kwapil , H. Le Bihan , P. L´’unnemann , F.
Martins, R. Sabbatini, H. Stahl , P. Vermeulen and Jouko Vilmunen, ‘Sticky Prices in
the Euro Area: A Summary of New Micro-Evidence’, Journal of the European Economic
Association 4 2006, pp.575–584.
Bils, M and P.J. Klenow, ‘Some Evidence on the Importance of Sticky Prices’, Journal
of Political Economy, 112 2004, pp.947–985.
70
6.7. Trends and business cycles
Cotis, J.P. and J. Coppel ‘Business cycle dynamics in OECD countries: Evidence, causes
and policy implications’, OECD, http://www.oecd.org/economy/growth/35125435.pdf.
Kuttner, K.N. and T. Robinson ‘Understanding the flattening of Phillips curve’, North
American Journal of Economics and Finance, 21 2010, pp.110–125.
6.7 Trends and business cycles

Most macroeconomic time series can be decomposed into its long-term (trend) and
short-term (business cycle) components. This distinction between short-term and
long-term is important for there is a consensus among economists that monetary policy
makers can only influence short-term fluctuations in output, and their constituent parts
such as consumption and investment. Most economists believe that the long-term
(trend) component in such time series is mainly driven by factors that are not easily
controllable by monetary or fiscal authorities, such as demographic changes and
long-term technological progress.
Figure 6.1 displays a stylised example of real GDP time series. Business cycles are
fluctuations of real GDP around its trend component. The lowest point of the business
cycle characterises the trough, whereas the highest point characterises the peak of the
business cycle. If the business cycle is below the trend we will refer to a negative output
gap, and if it is above the trend we will refer to a positive output gap.
Figure 6.1:
What do business cycles and trends look like in time series data? In Figure 6.2, we plot
seasonally adjusted real GDP levels in Germany, Turkey and the US for the period of
1960 Q1 – 2013 Q2 as reported by the OECD.
71
6. Stylised facts
Figure 6.2:
As can be seen from Figure 6.2, all series are trending upward with some cyclical
variations. We would like to decompose the data into its trend and business cycle
component and then analyse volatility, persistence and cyclicality of the business cycle
components. This cyclical component of the real GDP levels data is sometimes labelled
as the output gap.
Before we discuss how to extract the business cycle component from a level series, it is
useful to transform the data by taking its natural logarithms. There are various good
reasons for doing so. First, it rescales the time series from large numbers to more
reasonable numbers without affecting the time series properties significantly. Second,
the difference between the natural logarithms of two numbers is approximately the
percentage change in the series across time periods as long as the difference is rather
small. Third, graphically you can interpret the changes in the time series, since the
72
6.8. Moments
slope of the log of a series is approximately the growth rate.1

There are several ways of removing the time trend from the log level data; the simplest
being to remove a linear trend. If the trend in the data series is characterised by a
constant growth rate, removing the linear trend would be a good way to extract the
business cycle component. However, this is rarely the case and may be misleading. A
popular and better way to remove the trend from the level data is the application of the
Hodrick–Prescott (HP) filter.2 This filter removes a time varying trend by minimising
the sum of squared errors (remember the OLS regression) but incorporates a penalty
term λ to having the slope changing too rapidly. The minimisation problem is given by:
T
X T −1
X
min (xt − xG 2
t ) +λ [(xG G G G
t+1 ) − xt ) − (xt − xt−1 )]
2
(6.1)
T
( Gt )t=1
x t=1 t=2
where λ denotes the penalty parameter imposed on changing the slope of the smoothed
series, (xt )Tt=1 is the original real output data and (xG T
t )t=1 is the smoothed real output
series. When λ = 0, the HP filter will set xG t = xt for all t. There will be no smoothing.
When λ → ∞, the resulting trend will be linear. For quarterly data, typically, a λ value
of 1600 is assigned.
When we apply the HP filter to real GDP, consumption and investment data, we obtain
the following trend (Figure 6.4) and cyclical components (Figure 6.5) of the real output
series for the US.
6.8 Moments
After removing the growth trend from the data we would like to understand its business
cycle behaviour. As we have already taken natural logarithms, the business cycle
component is interpretable as a percent deviation of the variable from its growth trend.
As a next step we want to study their mean, volatility, cyclicality and persistence. Mean
is simply the average of the business cycle component of a variable. Volatility measures
how the variable of our concern fluctuates in time. Cyclicality shows how the business
cycle component of a particular variable evolves in relation to the business cycle
component of the real GDP. Persistence provides us a clue about the likelihood of a
variable to stay, say, above trend next period, when it is above trend in the current
period.
Means
The first moment of any time series is the sample average or the sample mean (x̄). To
calculate (x̄) of the business cycle component (xbc
t ) we use the following formula:
T
1 X bc
x̄ = x . (6.2)
T t=1 t
1
This implies that the constant growth is a straight line with log GDP.
2
Note that in Excel you can extract the business cycle component with the help of a macro file
(HPFilter.xla)
73
6. Stylised facts
Figure 6.3:
Given that the business cycle fluctuates around a trend component, by construction,
the sample mean is zero.
Standard deviation
The second moment of any time series is the variance around its mean. A sample
standard deviation (σx ) is simply the square root of the variance of the series.
v
u
u 1 X T
σx = t (xbc − x̄)2 . (6.3)
T − 1 t=1 t
The larger the deviations of a time series from its mean, the larger the sum will be on
average. In other words, a more volatile series will have a larger standard deviation.
Volatility measures how a particular variable fluctuates around over time. The standard
deviation of the HP filtered series serves as a measure for volatility.
In Table 6.1, we display standard deviations of the business cycle component of real
GDP, consumption and investment for three countries, Germany, Turkey and the US.
Table 6.1 shows two results we would like to take home. First, relative standard
deviations of the cyclical component of consumption to real output ratio are less than
one in Germany and the US. This is often interpreted as smoother consumption than
74
6.8. Moments
income over time. Note that for the same sample period cyclical consumption in Turkey
exhibits more volatility than income. Thus, consumption smoothing may not be such a
general rule, however, most macro-monetary models aim to explain less volatile
consumption relative to income. Second, in all these three countries, cyclical component
of investment is more volatile than income, roughly in the order of 3.
Figure 6.4:
Cyclicality
Another second moment about means is the covariance. It measures whether two
business cycle components, xbc and y bc , move in tandem. The sample covariance (σxy )
75
6. Stylised facts
(σx ) Germany Turkey US

σxbc 0.0169 0.0327 0.0135
σcbc 0.0138 0.0389 0.0106
σibc 0.0483 0.0977 0.0392
σcbc /σybc 0.82 1.19 0.78
σibc /σybc 2.86 2.99 2.90
Table 6.1: Volatilities.
between two variables is calculated as:
T
1 X bc
σxy = (xt − x̄)(ytbc − ȳ). (6.4)
T − 1 t=1
Terms in the sum may be clearly positive or negative. If two series tend to ‘comove’ in
the same direction, then whenever a term in series x is above its mean, then the
corresponding term in series y tends to be above its mean as well and whenever a term
in series x is below its mean, then the corresponding term in series y tends to be below
its mean as well. Therefore, a sample covariance will have mostly positive numbers
which yield a positive sum. The opposite is true, when two series co-move in the
opposite direction. A large covariance may make life somewhat difficult for us. It may
be due to high correlation between these two variables or both series may have large
variances that lead to large terms in the sum. In order to deal with this, we divide the
covariance by the two standard deviations. Resulting ratio is labelled as the ‘correlation
coefficient’.
σxy
ρxy = . (6.5)
σx σy
The correlation coefficient will be between −1 and 1. Highly correlated series will have a
correlation coefficient close to 1 in absolute value. If y represents the real GDP, a high
positive correlation coefficient with a series x indicates that the series x is ‘procyclical’.
Similarly, a high negative correlation coefficient with a series x indicates that the series
x is ‘countercyclical’. If the correlation coefficient is near zero, we label the series as
being ‘acyclical’.
Table 6.2 displays correlation coefficients of consumption, investment and real output in
the US, Germany and Turkey.
First, we observe that for each country, consumption and investment are positively
correlated with their real output, hence both consumption and investment are
procyclical variables. Second, although investment constitutes a smaller fraction in the
calculations of real GDP than consumption, the correlation coefficients between
investment and real GDP are somewhat higher than the correlation coefficients between
consumption and real GDP. Third, while the US business cycle to some extent seems to
be positively correlated with business cycles in Germany and Turkey, German and
Turkish business cycles appear to be slightly negatively correlated with each other.
76
6.8. Moments
Figure 6.5:
Persistence
To measure persistence in a variable we can use autocorrelations, that is the correlation

coefficient (ρx ) of a variable with the lagged value of itself. It is calculated as:
ax
ρx = (6.6)
σx2
with
T
1 X bc
ax = (xt − x̄)(xbc
t−1 − x̄). (6.7)
T − 2 t=2
A persistent series is more likely to stay above its mean in the next period when it is
currently above its mean. A highly persistent series will display an autocorrelation
coefficient closer to 1.
Table 6.3 displays autocorrelation coefficients for our quarterly series between 1984 Q1
and 2007 Q2 and these are large, implying high persistence in these time series.
77
6. Stylised facts
(ρxy ) cU S iU S y U S cGER iGER y GER cT U R iT U R yT U R

cU S 1 0.69 0.83 0.27 0.23 0.24 0.23 0.16 0.28
iU S 1 0.85 0.03 0.25 0.12 0.17 0.10 0.17
yU S 1 0.23 0.20 0.21 0.20 0.16 0.26
cGER 1 0.50 0.71 0.10 −0.07 0.02
iGER 1 0.77 0.04 −0.21 −0.11
y GER 1 0.02 −0.11 −0.07
cT U R 1 0.35 0.73
iT U R 1 0.77
yT U R 1
Table 6.2: Correlation coefficients.

(ρxi )
US
c 0.84
iU S 0.92
yU S 0.89
cGER 0.70
iGER 0.76
y GER 0.82
cT U R 0.66
iT U R 0.70
yT U R 0.77
Table 6.3: Autocorrelations.
Inclusion of more recent data-points after the financial crisis leads in most cases to a
slight decline in their persistence.
Autocorrelation coefficients for all series are quite large. When they are above (below)
the trend in the current period, they tend to remain above (below) the trend next
period. We conclude that series in our sample display strong persistence.
6.9 Cross country business cycle evidence

In an excellent recent paper, Calderon and Fuertes (2014) study business cycles of 71
countries (23 industrial countries and 48 emerging market economies, or EMEs), from
1970 Q1 to 2012 Q4. They report that
Recessions are costlier for emerging market economies (vis-à-vis industrial

economies). While recessions in emerging market economies are, on average, as long
as those in industrial countries, they are deeper and steeper.
Recoveries in emerging markets are slower and more volatile.
Recessions are on average shorter in duration, smaller in amplitude and less costly
during the globalisation period (1990–2007) when compared to the
pre-globalisation period (1970–89).
78
6.10. Key macroeconomic relationships
Recessions in East Asia are deeper than in Latin America and Eastern Europe,
however East Asian economies experience the fastest recoveries.
The behaviour of consumption and investment around recessions resembles that of

real GDP. Consumption fluctuates less than output for both industrial economies
and emerging markets. The opposite is true for investment.
Although both industrial and emerging markets have experienced deep recessions
during the recent global financial crisis, the emerging markets have recovered faster.
Activity 6.1 Calculate the business cycle component and its statistical properties
for the country you are living in by using excel.
6.10 Key macroeconomic relationships

We are also interested how real macroeconomic variables are related to nominal
variables, such as monetary aggregates, and prices in general. Such statistical
information is important. A theoretical macro-monetary models usefulness can only be
judged by its ability to fit the historical data and perhaps more importantly by its
ability to forecast the future. Next sections looks at some of these existing statistical
relationships found in the data.
6.10.1 Relationship between monetary aggregates and inflation
Inflation is always and everywhere a monetary phenomenon. M. Friedman and

A. Schwartz in ‘A Monetary History of the United States, 1867–1960’,
(Princeton University Press, 1963).
In the long run
Ever since the work by Friedman and Schwartz on the determinants of U.S. inflation,
there has been a strong consensus among economists that variations in monetary
aggregates are closely associated with variations in inflation over a reasonably long time
period. There is also broad agreement about the direction of causation: variations in
money lead to variations in inflation. This consensus has some theoretical support from
the so called Quantity Theory of Money (QTM) (See Chapter 5). In its simplest form,
the QTM argues that variations in some measure of money supply are followed by the
inflation rate. We can write the QTM directly in logarithmic differences (lowercase
letters) so that we can refer to changes in the variables concerned.
m+v =p+y (6.8)
where m represents the variations in money supply, p the inflation rate, y variations in
real income and v variations in the velocity of money supply. If we solve for the inflation
rate, p, we obtain:
p = m − y + v. (6.9)
79
6. Stylised facts
When we assume that variations in the money supply, m, do not impact the long run
real income, y, or velocity, v, money supply variations and inflation will be
proportional. In other words, a one per cent increase in the money supply will lead to a
one per cent increase in the inflation rate. To test the hypothesis De Grauwe and Polan
(2005) study 159 countries for the period of 1969–1999. First, they find a strong positive
relation between the long run growth rate of money and inflation. However, this relation
is not one to one. Second, they argue that this strong link between inflation and money
growth is mainly due to the presence of high inflation countries in their sample; there
seems to be no clear long run link between money growth and inflation in low inflation
economies. Third, they confirm the QTM assumption of no relationship between real
income and money growth in the long run. In other words money is long run neutral,
i.e. does not have permanent effects on output.
In the short run (Phillips Curve)
Phillips curve is an empirical inverse relationship between the rate of unemployment

and the rate of inflation in the short run.3 We will see later different versions of Phillips
curve in theoretical models as it provides a justification for the existence and relevance
of monetary policy in the short run. Here, we will simply state whether such
relationship is visible in the time series data. In Figure 6.6 we plot the annual
unemployment and the rate of inflation in the UK and the US together for the period
1971–2008. A simple correlation analysis shows that the contemporaneous correlation
between the UK inflation and unemployment for the whole sample period is in the order
of −59 per cent, whereas in the US the correlation is only about −5 per cent.
We also note that the contemporaneous correlations between inflation and
unemployment are changing over time. In the UK, there was a long lasting inverse
relationship between inflation and unemployment up to the global financial crisis. Note
that the negative relationship was already disappearing before the onset of the crisis. In
the US, there is a slight positive contemporaneous correlation up to the global financial
crisis. (Kuttner and Robinson (2010) provide an excellent discussion on why such
relationships may be changing over time; students are urged to read their paper). Of
course, these are simple correlations; we need to evaluate these relationships with the
use of advanced econometric techniques. We conclude that, while there is no clear
empirical support for a negative (positive) relationship between unemployment (output
gap) in the short-term, most theoretical business cycle models start with the premise
that the inflation-unemployment trade-off does exist in the short-term.
6.11 Relationship between monetary instruments and

macroeconomy
Standard macro-monetary analysis considers some measure of monetary aggregates or
short-term interest rates as potential monetary policy instruments to influence
macroeconomic variables. Economic research long understood the fact that a policy
3
Similarly, many researchers are interested in studying the relationship between the business cycle
component of real GDP (output gap) and the rate of inflation.
80
6.11. Relationship between monetary instruments and macroeconomy
Figure 6.6:
instrument can only be useful in the monetary policy implementation to the extent that
variations in the policy instrument over time regularly and reliably associated with
variations in income, prices, unemployment or any other variable the policy maker is
seeking to influence. The question for a policy maker is then choosing either a monetary
aggregate or a short-term rate as the policy instrument.
To answer the question, Friedman and Kuttner (1992) analysed the ‘information
content’ of variations in a range of US monetary aggregates and short-term interest
rates to explain variations in US real/nominal GDP and inflation. They conclude that
while monetary aggregates were useful in explaining US real output and inflation up
until the early 1980s, thereafter these lost their informational value, whereas short-term
interest rates or the spread between the commercial paper rate and Treasury bill rate
retained their information content in explaining movements in real income. Hence, not
surprisingly, starting from the early 1990s onwards, nearly all major central banks
focused on short-term interest rates as their policy variable. Currently, monetary policy
announcements of central banks are almost always about short-term interest rates.
81
6. Stylised facts
More recently, Aksoy and Piskorski (2006) argued that the loss of information content
in US monetary aggregates has actually something to do with the measurement of
monetary aggregates. In particular, they argue that as the US currency enjoys a reserve
currency position in the global financial and trade system, foreign holdings of the US
dollar are sizeable. Moreover, the foreign demand for the US dollar is changing over
time affecting the time series properties of the monetary aggregates. What matters for
the US domestic economic conditions is not the aggregate level of monetary aggregates,
but monetary aggregates corrected for the foreign holdings (domestic money). They
show that variations in domestic money contain valuable information in explaining
variations in not only US real income but also variations in US inflation. Thus, any
analysis, that does not take the international currency feature of US dollar into account,
may be misleading. In other words, money continues to be useful as an information
variable and a potential policy instrument.
6.12 Price level stickiness

Observed aggregate and good specific prices are rather sticky i.e. there is persistence in
price levels. Prices of goods and services do not adjust immediately in response to
changing demand and supply conditions. Similarly, inflation displays persistence. Using
individual price data, Alvarez et al. (2006) study frequency and size of price
adjustments in the euro area. They report that:
Prices change infrequently. In a given month 15.1 per cent of prices are changed
and the average duration of a price spell ranges from 4 to 5 quarters. These figures
mean that price adjustment in the euro area is considerably less frequent than in
the US (Bils and Klenow (2004)).
Frequency of price changes across products differ. Price changes are very frequent
for energy (oil products) and unprocessed food, while they are relatively infrequent
for non-energy industrial goods and services.
Differences across countries appear to be less important than cross-sector
differences.
On average, 40 per cent of the price changes are price reductions.
Price changes, either increases or decreases, are sizeable compared to the inflation
rate prevailing in each country.

By the end of this chapter, and having completed the essential reading and activities,
describe trends vs. business cycles

calculate the means, volatility, cyclicality and persistence of business cycle
components of macroeconomic variables
82
list key business cycle stylised facts
discuss the relevance of monetary aggregates and short-term interest rates as

potential policy instruments.

Section A
1. ‘Business cycles refer to fluctuations in the entrepreneurial activities.’
Section B
2. What is an HP Filter? Why is it important to extract the business cycle

component from the level data to analyse policy issues?
3. What are the key stylised facts in business cycle analysis that a theoretical model
should try to explain? Are there any differences between industrialised economies
and emerging market economies?
4. ‘Inflation is always and everywhere a monetary phenomenon.’ (Friedman and

Schwartz). Explain and critically discuss.
5. Is there empirical evidence in favour of Phillips curve? In the light of the discussion
in Kuttner and Robinson, provide an explanation for recent developments in in the
statistical relationship between output gap and inflation.

Section A
1. The statement is false. Suggested answers should include an exact definition of the
business cycle. A complementary stylised business cycle figure is recommended.
Section B
4. While there is some relationship between variations in money and inflation in the
long run, the relationship appears to be different between high and low inflation
economies. (De Grauwe and Polan (2005)). In the short run the relationship
appears to be weaker (Friedman and Kuttner (1992)). For the US one needs to take
83
6. Stylised facts
international currency feature of US dollar into account and only then apply the
relevant statistical analysis (Aksoy and Piskorski (2006)).
84
Chapter 7
Money, inflation and welfare
7.1 Introduction
In Chapter 5, we saw that in classical theory money was neutral, not having any effects
on real variables such as consumption or output. The welfare effects of money and
inflation, however, were not considered. Even if a change in the money supply does not
cause output or consumption to change, does it cause the utility or welfare of
individuals to be affected? This chapter will discuss such issues, noting the difference
between the neutrality and superneutrality of money. Finally, issues in hyperinflation
will be considered.
7.2 Aims
This chapter aims to study money, inflation and welfare in a flexible price environment.
It will introduce such concepts as the real and nominal interest rates, the
superneutrality of money, inflation tax and hyperinflations.

describe the relationship between real and nominal interest rates and why the
relationship holds
explain what superneutrality means and give examples of when monetary policy
can be neutral but not superneutral
define a monetary policy which maximises welfare and quantify the welfare cost
associated with a given level of inflation
describe the concepts of seigniorage and inflation tax
discuss the merits of using inflation as a source of government revenue rather than
other forms of tax
define hyperinflation, and explain why it is undesirable and how it forms.
85
7. Money, inflation and welfare
7.4 Reading advice

Before embarking on this chapter and before looking at any of the recommended
reading you should revise your understanding of inflation from your EC2065
Macroeconomics course. You should also have re-read Chapter 5 of the subject guide
on classical theory and monetary neutrality and the references therein. The model of
hyperinflation and that of high but stable inflation are based on the papers by Cagan
(1956) and Dornbusch (1992), respectively, and should be read after completing this
chapter.

Cagan, P. ‘The monetary dynamics of hyperinflation’, in Friedman, M. (ed.) Studies in
the Quantity Theory of Money. (Chicago: University of Chicago Press, 1956).
Dornbusch, R. ‘Lessons from experience with high inflation’, The World Bank Economic
Review (6) 1992, pp.13–31.
University Press, 2000) Chapter 7.
Macmillan, 1989) Chapters 6 and 7.
7.6 Further reading

Books
Cagan, P. ‘Hyperinflation’, in Newman, P., M. Milgate and J. Eatwell (eds) The New
Danthine, J.P. ‘Superneutrality’, in Newman, P., M. Milgate and J. Eatwell (eds) The
New Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994).
Friedman, M. ‘The quantity theory of money’, in Newman, P., M. Milgate and J.
Macmillan, 1994).
Mankiw, N.G. Macroeconomics. (New York: Worth Publishers, 2002).
Journal articles
Diamond, P.A. ‘Search, sticky prices and inflation’, Review of Economic Studies 59(4)
1993, pp.53–68.
Sargent, T. and N.Wallace ‘Some unpleasant monetarist arithmetic’, Federal Reserve
Bank of Minneapolis Quarterly Review 531 (1981), Fall.
86
Neutrality
In the classical model, which we assume here, prices are perfectly flexible and the
economy is then one in which output is always at (full employment) equilibrium. We
will also not consider other sources of non-neutrality such as contracts or debts
denominated in nominal terms. In such an economy, as established in Chapter 5, money
is neutral in the sense that in static equilibrium all real variables in the economy are
independent of the quantity of nominal money and the price level is proportional to the
quantity of money.
It might appear that an immediate implication of neutrality is that the rate of growth
of the quantity of money would also be neutral in the sense of affecting the rate of
growth of the price level (inflation) but no real variables. This is known as
‘superneutrality’. Then inflation would indeed be a monetary phenomenon and at the
same time would have no real effects. However, it turns out that even in a flexible price
economy this implication is not correct, the reason being that expectations of the future
growth rate of the quantity of money create expectations of inflation and expectations of
inflation are not neutral. The starting point is the distinction between real and nominal
interest rates, and the relationship between them; the ‘Fisher equation’.
Real and nominal interest rates
If people expect there to be inflation over some period, quoted interest rates no longer
represent the rate at which goods today can be traded for goods in the future. Imagine
a deposit paying a fixed interest rate, Rt % per annum on balances at the beginning of
period t, paid at the beginning of period t + 1. Then £100 today becomes £100(1 + Rt )
in a year’s time. However, if the price level at the beginning of the year were Pt , and
prices were to rise during the year at a rate πt+1 (πt+1 being the inflation rate between
periods t and t + 1), the quantity of goods that can actually be purchased at the end of
the year is £100(1 + Rt )/Pt (1 + πt+1 ). Thus not consuming £100/Pt goods at the
beginning of the year enables one to consume £100(1 + Rt )/Pt (1 + πt+1 ) more goods at
the end of the year. For small values of Rt and pt+1 , this expression can be
approximated by £100(1 + Rt − πt+1 )/Pt , and the term (Rt − πt+1 ) is known as the
‘real’ rate of interest, rt . The relationship between the real and nominal rate of interest,
which is known as the Fisher equation, is therefore by definition:
rt = Rt − πt+1 . (7.1)
While a borrower or financial institution can commit to a particular nominal interest

rate at the beginning of the period, it is evident that the actual rate of inflation over
that same period, between t and t + 1, will not be known until date t + 1. Hence at the
beginning of the period, borrowers and lenders can only form expectations of the real
interest rate based on their expectations of inflation over the period.
The ex-ante real interest rate, rtA , measures the quantity of goods at the end of the
period which people expect to be able to buy as a proportion of the quantity they
could buy today with the money they deposit or lend. Then:
rtA = Rt − πt+1
e
(7.2)
87
e
where πt+1 is the expected rate of inflation between dates t and t + 1, formed at
date t.
In the same way the ex-post real interest rate, rtP , measures the actual real interest
rate during some past period, which is the quantity of goods at the end of the
period that a depositor was actually able to buy relative to what could have been
bought at the beginning. Evidently,
rtP = Rt − πt+1 . (7.3)
In measuring ex-post real interest rates it should be noted that current quoted
nominal interest rates relate to the future whereas quoted inflation rates refer to
the past, hence the different time subscripts. If one wanted to know the ex-post real
interest rate for 2002 it would be necessary to subtract the 2002 inflation rate (as
recorded at the end of the year/beginning of 2003) from the nominal rate quoted
for one-year money at the beginning of the year.
If everyone correctly forecasts the rate at which prices will rise over some period and
acts on the basis of these expectations, inflation is said to be fully anticipated. In this
e
case of course, πt+1 = πt+1 , and the ex-ante and ex-post real interest rates are therefore
equal.
Activity 7.1 How can borrowers commit to paying the real rate of return on any
sums lent to them?
Superneutrality
Superneutrality may be defined as the proposition that, where inflation is fully

anticipated, the real rate of interest (rt ), is independent of the fully anticipated inflation
rate, πt+1 . The real rate of interest measures the relative price of goods in the future as
against goods today so it is clearly a ‘real’ variable relevant to intertemporal decisions
(saving and investment). If it were to change in response to a change in the inflation
rate, then inflation would not be neutral in that it would affect savings and investment
decisions. However, if the real interest rate does not change when the inflation rate
changes, then from the Fisher equation, it follows that the nominal rate, Rt , must
adjust one-for-one with changes in the inflation rate.
In the standard macro model, the real interest rate affects the goods market through its
effects on saving and investment decisions. From the resource constraint; output, Y , is
split between consumption, C, investment, I, and government spending, G, we can
write:
+ − + −
Y = C Y − τ, r + I Y , r + G. (7.4)
τ are taxes so that consumption depends positively on disposable income and negatively
on the real interest rate. A high real interest rate will encourage saving (decrease
current consumption) as one unit of consumption goods today can yield a larger
number of consumption goods tomorrow. There is then a negative relationship between
the real rate and output.
−
r=H Y . (7.5)
88
From the Fisher equation:

−
R = H Y + π. (7.6)
Equation (7.6) represents an IS curve, showing the combinations of output, Y , and

nominal interest rate, R, that clear the goods market.1 Therefore, in the standard
IS–LM model with the nominal interest rate on the vertical axis, an increase in the
inflation rate will shift the IS curve upwards but leave the position of the LM curve
unchanged. There must therefore be a one-off increase in the price level to restore
equilibrium in the money market at the given level of equilibrium output, see Figure
7.1. The increase in the nominal interest rate reduces the demand for real money
balances and the jump in the price level reduces the supply.
Figure 7.2 shows (by way of concrete example) the case of a static economy, where
initially the stock of money and hence the price level are constant, and where at time t0
a new policy is introduced such that the money stock grows at g% per year. The growth
in the money stock will cause prices to increase, also at g% per year, and the
anticipation of this inflation at time t0 will cause the nominal interest rate to jump at t0
by g percentage points. This in turn will cause the price level to jump at time t0 by an
amount equal to g multiplied by the interest elasticity of the demand for money. In this
standard model, changes in the fully anticipated inflation rate leave the real interest
rate unchanged but affect not only the nominal interest rate but also the stock of real
money balances, and it is this which leads to the welfare costs of fully anticipated
inflation (see below).
Figure 7.1: Superneutrality of money.
The standard model is somewhat simplified in that it has no wealth effects in the IS
curve. A full and general model would include such effects, and in such a model a fall in
real money balances would constitute a fall in wealth, which would tend to raise savings.
A rise in savings would shift the IS curve inwards and thus lower the equilibrium real
interest rate and increase investment. This is known as the Mundell–Tobin effect. It
says that in inflationary times people wish to hold less wealth in the form of real money
balances and therefore attempt to acquire other forms of wealth including real capital.
1
While IS–LM model used to analyse economies with short term price stickiness, remember that there
are no such rigidities in this model.
89
Figure 7.2: Nominal money balances and the price level.
In practice, however, in most advanced economies fiat money balances constitute so tiny
a proportion of people’s wealth that this effect can be ignored.
Figure 7.3: Non-superneutrality of money.
The case of non-superneutrality, caused by wealth effects in the consumption function,

is shown in Figure 7.3. The IS curve is derived from an amended version of (7.4).
 +


+ − M + −
Y = C Y − τ, r,  + I Y , r + G. (7.7)
P
Alternatively, this can be written in the form:

 +

− M
r = H Y , . (7.8)
P
For any given output level, a fall in real money balances necessitates a fall in real
interest rates in order to offset the decrease in aggregate demand. In goods market
90
equilibrium there is then a positive relationship between M/P and r. Following the
increase in inflation, caused by the positive growth rate of nominal money balances, the
IS curve shifts out as in Figure 7.1 but is partially offset because of the fall in wealth
(fall in M/P ) which reduces consumption. The nominal interest rate only increases to
R10 (< R1 in Figure 7.1) and since inflation is the same in both Figure 7.1 and Figure
7.3, the real interest rate, r10 , will be less than r0 , (i.e. the real rate has fallen).
The welfare costs of inflation and the optimal quantity of money
The key insight, which follows from Friedman’s price-theoretic approach to modelling
the demand for money, is that the area under the demand curve measures the utility
derived by individuals from holding money balances. The opportunity cost to
individuals of holding money balances is measured by the nominal rate of interest, R.
The consumers’ surplus enjoyed by individuals from holding money balances, that is,
the excess of the utility they derive over the opportunity cost they incur, is thus
measured by the area A in Figure 7.4.
Figure 7.4: Seigniorage and inflation tax.
Figure 7.5: . . . with positive inflation.
Suppose that, initially, there is no inflation, so that the nominal interest rate in Figure
7.4 is equal to the real interest rate (R0 = r). Given this interest rate, the total stock of
91
money balances, which individuals wish to hold, is denoted (M/P )0 . The area B
measures the annual income stream the government as issuer of money is able to
acquire by the once and for all purchase of productive assets with the money it issues.
(In a static economy with no inflation, the stock of money outstanding is constant, but
the government was able to acquire real assets with it at the time it was introduced.)
But if the money is fiat money, the cost of production is approximately zero, so the
government is essentially able to acquire real assets ‘for free’ by virtue of its monopoly
position on the money issue. This is known as ‘seigniorage’, and it represents a transfer
of resources from money holders (households and firms) to the government.
Seigniorage is essentially a form of taxation, and the area C in Figure 7.4 is the excess
burden or deadweight loss associated with this tax. Holdings by individuals of money
balances in excess of (M/P )0 yield positive utility and the additional money costs
nothing to produce. Therefore, there would be economic benefit from expanding the
quantity of real money balances held from (M/P )0 up to the point of ‘full liquidity’, L.
However, this cannot be done through an expansion of the nominal money stock,
because with an interest rate of R0 the desired holding of money balances is (M/P )0 ,
and any additional nominal money will lead to an increase in the price level to restore
the desired quantity of real balances.
The social utility of money in Figure 7.4 is measured by the area A + B, the sum of
consumers’ surplus and the revenues obtained by the government from seigniorage.
Given the demand curve, the maximum possible social utility that could be achieved is
when the holdings of money balances are at L (full liquidity), which is Friedman’s
‘optimal quantity of money’. To induce individuals to hold the optimal quantity of
money it is necessary that the nominal interest rate be zero. Only in this case will the
demand for money be equal to L. Given the Fisher equation, the nominal interest rate
will be zero when the rate of price inflation is equal to minus the real interest rate (i.e.
R = 0 when p = −r).
The welfare cost of fully anticipated inflation arises because inflation raises the nominal
interest rate, reducing the demand for real money balances and therefore reducing the
utility obtained from the use of money. In Figure 7.5 we consider an economy with fully
anticipated inflation at a rate of p1 . The nominal interest rate is now R1 (= r + p1 ), and
the demand for money is (M/P )1 . The consumers’ surplus is again measured by the
area under the demand curve and above the opportunity cost of holding money, and is
therefore the area A. The area B + D represents the revenue the government now
derives from money issue, of which B is generally known as the ‘inflation tax’, and as
before, D is seigniorage, real interest rate times real money balances. The inflation tax
refers to the resources obtained by the government by the continuing process of printing
money during times of inflation. (If the inflation rate is p1 , and the volume of real
money balances (M/P )1 , the amount of nominal money the government will need to
print per period to maintain the real stock of money constant is p1 (M/P )1 .)
Comparing Figure 7.4 with Figure 7.5, the welfare cost of inflation may be measured as
the loss of consumers’ surplus, B + C, plus the loss of seigniorage, E, less the inflation
tax revenue, B.
Welfare cost = B + C + E − B = C + E. (7.9)
This is equal to the reduction in the quantity of real money balances demanded
multiplied by the nominal interest rate averaged over that range. The welfare cost of
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7.7. Inflation as taxation
fully anticipated inflation arises because individuals choose to incur the cost and
inconvenience of economising on money balances in times of inflation. Inflation raises
the private cost of holding money balances though the social cost of creating money
remains negligible.
7.7 Inflation as taxation

If inflation is like a tax it not only reduces demand and has welfare costs, but also raises
revenue for the government. Even though inflation has welfare costs, these costs may be
lower than those of other forms of taxation. Returning to Figure 7.5, the net increase in
government revenue from inflation is the inflation tax, area B, less the reduced yield
from seigniorage, area E. If one measures the efficiency of a tax as the ratio of the
welfare cost to the revenue raised, then the efficiency of inflation as a form of taxation is
given by:
C+E
Efficiency = . (7.10)
B−E
The most efficient tax scores zero on this scale (no welfare cost) and the least efficient
scores infinity (welfare cost but no revenue yield), or negative if the tax actually lowers
total revenue. The relationship between the welfare cost and the revenue raised by the
inflation tax depends on the interest elasticity of demand for money. The more inelastic
the demand for money, the more efficient is inflation as a form of taxation.
Activity 7.2 What other factors, other than efficiency, should determine the extent
to which the government uses inflation as a form of taxation?
Hyperinflation
The popular image of hyperinflation is of very rapid, and in particular very rapidly
accelerating, inflation, leading to astronomical prices and to a collapse of the monetary
system. The most famous hyperinflation of this type in a major industrial country was
Germany in 1922–23. Prices increased by 500,000 times within the space of a few
months in the autumn of 1923, the prices of staple commodities like a loaf of bread or a
newspaper ran into hundreds of billions of marks. Notwithstanding this, money
remained the medium of exchange, although the attempt to spend money as soon as it
was received itself generated faster inflation. The greatest cost of the hyperinflation,
however, was the impoverishment of households with monetary assets whose value was
destroyed.
Hyperinflations of this type result from political instability such that the government is
unable to finance its expenditure except through money creation. The acceleration of
inflation results in part from deteriorating public finances and in part from the ‘flight of
money’ caused by expectations of faster inflation. In the twentieth century, there were
hyperinflations after the First World War in Austria, Germany, Hungary, Poland and
Russia, and after the Second World War in Bulgaria, Greece, Hungary, Poland and
Romania. More recently, there have been hyperinflations associated with the collapse of
the former Soviet Union and with the effects of war, in particular in parts of former
Yugoslavia (e.g. Serbia).
93
Activity 7.3 What has been the highest rate of inflation in your country?
These rapidly accelerating hyperinflations are unsustainable, and are usually terminated
by a financial reconstruction involving a new government, a new currency whose value is
sometimes secured by a fixed exchange rate or currency board, and a fiscal
reconstruction that may involve a repudiation of government debt or other obligations.
To demonstrate how hyperinflations can lead to a collapse in the demand for money,
consider the model of money demand by Cagan (1956). Take a standard money demand
equation of the form:
M
ln = ayt − bRt . (7.11)
P t
Replacing Rt with rt + pet+1 from the Fisher equation, this can be written as:
e
ln Mt = ln Pt + ayt − brt − bπt+1 . (7.12)
Differentiate this with respect to time and assume that output growth and real interest
rate changes are small relative to changes in nominal quantities, as is likely in periods of
hyperinflations, which is what the Cagan model tries to study.
e
d(ln Mt ) d(ln Pt ) d(πt+1 )
= −b . (7.13)
dt dt dt
d(ln Mt )/dt is the growth rate of the money supply, mt , and d(ln Pt )/dt is the growth
rate of the price level, or inflation, πt . Rearranging gives:
e
d(πt+1 )
πt = mt + b . (7.14)
dt
e
If inflation is expected to increase in the future (i.e. d(πt+1 )/dt is positive), then these
expectations can cause inflation to increase to a level above mt . Increases in inflation
will cause individuals to increase their expectations of inflation, which in turn causes pt
to increase even further from (7.14). The collapse in the demand for money is then
partly caused by expectations of faster inflation next to growth rate of the money
supply (mt ), which are, ultimately, self-fulfilling.
Very rapid, continuing and non-explosive inflation
A more recent phenomenon has been a widespread experience of very rapid but none the
less continuing and non-explosive inflation. For example, there have been inflation rates
averaging over 100 per cent a year lasting for 10 years or more in many South American
countries such as Argentina, Brazil or Peru during the 1980s. Such very rapid but stable
inflations can be explained in terms of a continuing but non-deteriorating government
deficit. This can be demonstrated in the form of a very simple model due to Dornbusch.
Assume a government whose expenditure falls short of the money it can raise from
taxation by some amount, which is a fixed proportion, g, of nominal income. The
government has a poor credit rating and is unable to borrow from the capital markets
so this deficit can be financed only through the creation of money. The deficit per unit
time period is given by:
Deficit = gP y (7.15)
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7.7. Inflation as taxation
where P is the price level and y is real GDP. This deficit is financed by an increase in
the money stock, so that:
dM
= gP y. (7.16)
dt
In the simplest version of the model the monetary sector is described by the quantity
theory equation:
M V = Py . (7.17)
Dividing (7.16) by (7.17) gives:

1 dM
· = gV. (7.18)
M dt
But (1/M ) · (dM/dt) is equal to the growth rate of the money supply, which is equal to
the rate of inflation, p. This leads to the very simple expression for the inflation rate
under these assumptions of:
π = gV. (7.19)
For large values of g and/or V the inflation rate can be quite rapid, but in the simplest
versions of this model there is no reason why it should accelerate. A straightforward
modification of the model is to allow the velocity of circulation to be increasing in the
inflation rate, V = V (π) with V 0 > 0, which may lead to a deteriorating trade-off
between the deficit and inflation and to the possibility of instability. See Figure 7.6.
If we are initially at point E’ and inflation increases, this will cause velocity to increase
since V = V (π). Higher velocity will cause inflation to rise (π = gV ) and the process
continues with ever increasing inflation. Point E’ is therefore an unstable equilibrium.
Figure 7.6:
Activity 7.4 Explain, using Figure 7.6, why point E is a stable equilibrium. (Hint:
start by examining what happens when inflation increases slightly from point E.)
95
Activity 7.5
1. In the economy of Mythica, prices are perfectly flexible and output is always at
its full employment level, Y . The velocity of circulation of money is constant,
and the stock of money, M , grows at a constant rate, m. Aggregate demand,
the IS curve, is given by Y d = A − b(R − π e ), where R is the nominal rate of
interest and π e is the expected rate of inflation.
(a) What is the inflation rate, π, in Mythica?
(b) If the inhabitants of Mythica have perfect foresight, what is the effect of
increasing the growth rate of the money supply on real and nominal
interest rates?
(c) Is the stock of real money balances affected by the rate of growth of the
money supply?
Imagine now that due to an increase in financial sophistication in Mythica the
demand for money becomes sensitive to the interest rate so that in place of the
quantity theory equation, we have (M/P )d = H − kR. How are your answers to
parts (a) to (c) above affected by this development? Is money i. neutral, and ii.
superneutral in Mythica?
2. An econometrician makes the following estimates of the key economic

parameters of the Mythican economy. Y = 1000, and in the IS equation
A = 1400 and b = 100. In the money demand equation H = 1200 and k = 50.
The government of Mythica is committed to a policy of price stability and
hence the rate of growth of the money supply, µ = 0, and the stock of nominal
money balances is 2000. If interest rates are measured in percentage points, so
for example a 7% interest rate means R = 7, then:
(a) Calculate the nominal interest rate, the price level and the stock of real
money balances in Mythica.
(b) What value of seigniorage does the government derive from its monopoly of
the money issue?
If the government were instead to allow the money stock to grow at a rate of
10% per annum, µ = 10, what will happen to the inflation rate, the nominal
interest rate and the stock of real money balances in Mythica? What resources
does the government now derive from the combination of inflation and
seigniorage? (For feedback, see the end of this chapter.)

describe the relationship between real and nominal interest rates and why the
relationship holds
explain what superneutrality means and give examples of when monetary policy
96
can be neutral but not superneutral
define a monetary policy which maximises welfare and quantify the welfare cost
associated with a given level of inflation
describe the concepts of seigniorage and inflation tax
discuss the merits of using inflation as a source of government revenue rather than
other forms of tax
define hyperinflation, and explain why it is undesirable and how it forms.

Section A
1. ‘The government of Zeroland acquires a fixed quantity, G, of real goods and

services per capita each year, which it purchases through printing fiat money. It has
no other income. If there is no economic growth in Zeroland, and velocity of
circulation, V , of money is constant, the inflation will be independent of G.’
Section B
2. What is meant by the ‘superneutrality’ of money? How does it relate to the Fisher
equation? If money is superneutral, does it follow that inflation has no welfare
costs?
3. Assume that the government can control the rate of inflation exactly. What rate
should it set? Outline arguments in favour of positive, zero and negative inflation
rates.
4. What causes hyperinflation? How can hyperinflations be stopped?
5. Consider the economy of Mythica in Activity 7.5, noting the values of the variables
in part 2.
(a) If monetary policy affects social welfare only through its effect on the
consumer surplus obtained from the use of money, what rate of monetary
growth maximises social welfare in Mythica? What is the nominal rate of
interest in this optimal regime?
(b) If the government of Mythica can finance its expenditure only through money
creation, what is the relationship between government expenditure as a
proportion of GDP (g) and the growth rate of the money stock? Is there a
limit to the expenditure, which can be financed in this way?
97
1. First part.
(a) Take logs of the quantity theory and differentiate with respect to time. Use
(7.2) and (7.3) to show that inflation is equal to m.
(b) Perfect foresight implies inflation is equal to m at all times. From the IS
equation and the fact that Y is constant, r (= R − π) must therefore be
constant. The real interest rate is constant and the nominal interest rate
moves one-for-one with the inflation rate.
(c) From the quantity theory, M V = P Y , M/P is constant and so not affected by
the rate of growth of the nominal money supply.
Second part.
(a) Differentiate the money demand equation with respect to time, noting that
dR/dt = 0 in equilibrium.
dM 1 dP M
· − · = 0.
dt P dt P 2
From which we can see that the growth rate of money equals the growth rate
of prices. π = µ.
(b) Same as in the first part.
(c) From the money demand equation, it is clear that an increase in R, caused by
the increase in µ, will cause the demand for real money balances to fall. The
price level jumps in order for the real money supply to equal the lower real
money demand.
Money is neutral in Mythica; increasing the money supply just increases the price
level with no change in any real variables.
Money is, however, not superneutral. Increasing the growth rate of the money
supply causes a real variable, M/P , to fall. The real interest rate, however, remains
unchanged.
2. First part.
(a) R = 4% from the IS equation. Substituting into the money demand equation
gives P = 2 and hence M/P = 1000.
(b) Seigniorage equals the real interest rate multiplied by real money balances.
Therefore seigniorage equals 4000.
Second part.
(a) M = 10% therefore π = 10%. Since R = 4%, R must equal 14% and from the
money demand equation, M/P = 500.
(b) Seigniorage equals 2000 and the inflation tax, inflation rate multiplied by real
money balances, equals 5000. Total revenue therefore equals 7000.
98

Section A
1. The statement is false. Suggested answer will use and explain (7.15) to (7.18) to
show that inflation is equal to GV .
Section B
5. (a) The money demand equation is (M/P )d = 1200 − 50(r + π). If social welfare is
maximised by maximising the consumer surplus under the money demand
curve, then welfare is maximised when i = 0 (Friedman rule). If r = 4% and
i = r + π, then welfare is maximised when π = −4%. Hence, in order to
maximise welfare, the money supply should contract by 4% per year, µ = −4%.
(b) Using the model of Dornbusch, government spending is financed by money
creation. (Ignore seigniorage here; government spending is only financed from
the inflation tax).
dM
= gP Y.
dt
Dividing by P and noting that (dM/dt) · 1/M = µ, the growth rate of money,
gives:
M
µ· = gY.
P
Substituting in for M/P (= 1200 − 50i) and using i = r + π (= 4 + π) and
π − µ, together with our value for Y (=1000):
µ(1200 − 50(4 + µ)) = 1000g.
Rearranging gives
g = µ − 0.05µ2 .
This is the relationship between the money growth rate, µ, and the proportion
of GDP that the government can spend, financed only through money
creation. Differentiating this with respect to µ and setting equal to zero will
give a maximum value of g of 5%. This is associated with a money growth rate
of 10%.
99
100
Chapter 8
Classical models and monetary policy
8.1 Introduction
In Chapter 5 we introduced the classical model where money was neutral. Real
outcomes such as investment decisions and output were determined by real factors;
tastes and technology, and the money supply only determined the price level. In this
chapter we will examine classical models in more detail, exploring the possibilities that
monetary policy can have real effects, at least in the short run. However, in order for us
to do this, we must first consider the benchmark case of the classical model and we do
this by considering a model based on ‘reduced form’ macro equations.1
A ‘simple’ model is introduced and solved in the appendix but you are not expected to
develop, or be able to solve, these models in the examination. They are purely left for
the more interested reader who wishes to further understand how RBC theory works.
8.2 Aims
This chapter introduces first major macro model without nominal ‘frictions’ that will
serve as a benchmark model. We then study cases with real frictions in the classical
model (in the form of asymmetric information, the requirement to hold cash before you
could buy, and limited participation in financial markets) all lead to money having real
effects.

describe how, in the classical economy, output is determined by the factor markets
describe and discuss the effects of monetary policy, with reference to the effects of
money on nominal variables such as prices and nominal wages, and on real
variables such as employment
describe what business cycle models are and what they try to do
list and explain the workings behind, the flexible price models where money has
real effects.
1
I.e. equations we assume hold in this particular instance.
101
8. Classical models and monetary policy
8.4 Reading advice

Before working through this chapter, it is vital that you have a thorough understanding
of the macroeconomic classical models. Background reading can be found in the
textbooks of Mankiw (2002) and Branson (1989) among others.
In this chapter, we discuss the Classical model in more detail, analysing the effects of
monetary policy.
Once you have worked through the chapter, you can read the articles in the reading list;
those of Long and Plosser (1983) and Plosser (1989) are probably the most readable.
The chapters in Hoover and in Hargreaves Heap are also very useful.

Hargreaves Heap, S.P. The New Keynesian Macroeconomics: Time, Belief and Social
Independence. (Aldershot: Edward Elgar Publishing, 1992) Chapter 4.
Hoover, K.D. The New Classical Macroeconomics. (Oxford: Blackwell, 1988) Chapter 3.
Long, J. and C. Plosser ‘Real business cycles’, Journal of Political Economy 91(1) 1983,
pp.39–69.
Plosser, C. ‘Understanding real business cycles’, Journal of Economic Perspectives 3(3)
1989, pp.51–77.
8.6 Further reading

Books
Branson, W.H. Macroeconomic Theory and Policy. (New York; London: Harper and
Row, 1989).
Walsh, C.E. Monetary Theory and Policy. (Cambridge, Mass.: MIT Press, 2003)
Chapter 1.
Journal articles
King, R.G. and C. Plosser ‘Money, credit and prices in a real business cycle’, American
Economic Review 74(3) 1984, pp.363–80.
Kydland, F.E. and E.C. Prescott ‘Business cycles: real facts and a monetary myth’,
Federal Reserve Bank of Minneapolis Quarterly Review 14(2) 1990, p.3.
Lucas, R.E. Jr. ‘Some international evidence on output-inflation trade-offs’, American
Economic Review 66(5) 1976, p.985.
Lucas, R.E. Jr. ‘Nobel lecture: monetary neutrality’, Journal of Political Economy
104(3) 1996, pp.661–82.
102
8.7. The classical model revisited
8.7 The classical model revisited

As should be clear by now, in the classical model all markets do clear instantaneously
such that output is at its natural rate, resulting in involuntary unemployment being
equal to zero. Note that the labour market variable is hours worked, not the level of
employment, thus when individuals decide to work they always find work at a given
wage rate. Prices are perfectly flexible and move instantly to clear both goods markets
and factor markets (the prices in the labour and capital factor markets are wages and
real rates, respectively). We shall assume that output in the economy is determined
only by labour and capital.
y = f (k, l) (8.1)
where k is the amount of capital, which for the time being we will assume to be fixed,
and l is the amount of labour. Also, f1 (the derivative of the production function with
respect to the first element) > 0, f2 > 0, f11 < 0, f22 < 0 and f12 > 0. That is, factors
are complementary in production and they have positive but decreasing marginal
productivities. The demand for labour by firms will depend negatively on the real wage
that they have to pay, W/P . If labour is more expensive, firms will demand less of it.
Firms demand labour up to the point where the marginal cost of production, the real
wage, equals the marginal benefit from production, the marginal product of labour. Due
to the properties of the production function, namely diminishing marginal returns, a
high level of labour is associated with a low marginal product so firms are only willing
to pay a low wage at that employment level. The supply of labour is positively related
to the real wage since a high wage encourages individuals to work more hours and
causes those who initially chose not to join the labour force, to participate in work.
Labour market equilibrium is shown in Figure 8.1. If capital is fixed at k ∗ , then output
is determined as y = f (k ∗ , l0 ).
8.8 The effect of monetary policy

The effect of monetary policy can be best shown using the set of diagrams in Figure 8.2,
below.
The middle left diagram shows the labour market equilibrium. This is the same as
Figure 8.1 only we have the nominal, as opposed to the real, wage on the vertical axis.
This is because we are examining the effects of changing nominal variables, namely the
nominal money supply.
The bottom left diagram is the production function for a given level of capital, k ∗ , and
shows the decreasing marginal returns to labour.
The top right panel shows the standard IS–LM analysis and the middle right panel
shows the aggregate demand and supply schedules. Note that the aggregate supply
schedule is vertical in the classical model since markets always clear which allows
output always to equal its natural/full employment rate, y 0 .
Suppose the famous ‘helicopter drop’ analogy of monetary policy of Friedman. Imagine
an economy, where authorities conduct monetary policy by sending off helicopters to
drop cash over the country. Such an increase in the money supply, caused by a
103
Figure 8.1: Labour market equilibrium.
‘helicopter drop’ of newly printed money or by open market operations, whereby the
monetary authorities buy government bonds in exchange for money, leads to an
outward shift of the aggregate demand curve to AD1 .2 The monetary expansion also
causes the LM curve to initially shift out to LM1 . However, the increase in demand has
no effect on output since the AS schedule is vertical at y 0 , and simply causes the price
level to increase from P0 to P1 . The increase in the price level reduces real money
balances, causing the LM curve to shift back to its initial position, LM0 . Note that
although the outward shift of the LM curve, caused by the initial monetary expansion,
suggests at least a temporary increase in output, the price level increases immediately
so that the LM curve effectively never changes position.
The increase in the price level causes the labour demand schedule to shift out. Note
that we have the nominal wage on the vertical axis. For any given nominal wage, a
higher price implies a lower real wage and hence an increase in labour demand. The
price rise also causes the labour supply schedule to shift to the left. Again, for any given
nominal wage, the price rise implies a fall in the real wage so individuals supply less
labour. In equilibrium the nominal wage increases to the point where the real wage
remains at the initial level. Real wages and real money balances are left unchanged in
equilibrium; and output, labour, and so on are all unaffected. All the change in the
money supply does is to change other nominal variables, nominal wages and prices,
one-for-one. Money, as expected, is neutral.
2
Why a change in nominal money balances affects the AD schedule is documented in all
macroeconomic texts. See for example Mankiw (2002).
104
8.8. The effect of monetary policy
Figure 8.2:
105
8.9 Real business cycle theory

Real business cycle (RBC) theory extends the classical model in that it derives the ad
hoc macroeconomic equations, represented in Figure 8.2, from the optimising behaviour
of agents. Money still turns out to be neutral in the basic set-up but business cycles are
argued to be the natural and efficient responses of the economy to changes in the
available production technology. It distinguishes between nominal shocks (shocks to
money supply or money demand) which only affect the LM curve and real shocks
(shocks to the production function, real government spending or to savings and
consumption decisions) which affect only the IS or AS curves.
According to RBC theory, real shocks to the economy are the primary cause of business
cycles. The theory focuses on shocks to the production function: supply shocks or
productivity shocks. Such shocks can be the result of:
the development of new products or production methods
changes in the quality of labour or capital
changes in the availability of raw materials
unusually good or bad weather and
changes in government regulations affecting production.

Economic booms result from beneficial productivity shocks and recessions are caused by
adverse productivity shocks. Consider a temporary adverse supply shock. The marginal
product of labour falls as labour becomes less productive, which reduces the demand for
labour. Both the real wage and the equilibrium level of employment fall. The latter
causes a fall in output (a recession).
8.10 Business cycle facts and RBC theory

RBC theory does a good job at explaining a number of the stylised facts of the
macroeconomy and of the business cycle. RBC models explain the procyclical nature of
employment, labour productivity and the real wage and also explain why investment is
more volatile than consumption.3 This last point is explained by the fact that agents,
being riskaverse, prefer to smooth consumption streams over time. Any fluctuations in
income due to productivity shocks will be absorbed into the saving/investment
decisions of individuals, resulting in smooth consumption and volatile investment.
However, despite explaining these features of the business cycle, it is, in reality, very
difficult to identify the productivity shocks that cause the cyclical fluctuations. Also, in
order to explain the large cyclical fluctuations in hours worked and the small cyclical
fluctuations in the real wage observed in the real world, RBC theory needs a flatter
aggregate labour supply curve than has been found by most studies. RBC theory also
predicts that the price level will be countercyclical when the empirical evidence for real
output and inflation is, as we saw in the ‘Stylised facts’ chapter, not conclusive. Also,
3
We define a variable as being procyclical (countercyclical) if it moves positively (negatively) with
output.
106
8.11. Classical models with real effects of money
RBC theory, being an extension of the classical model, suggests that money is neutral.
However, the problem with claiming that money is neutral is that the money stock has
been found to be a leading, procyclical variable. RBC theorists argue that the apparent
relationship between money and output is one of reverse causality; anticipated changes
in output lead to changes in the money supply in the same direction. Historical research
as discussed in Chapter 7, however, suggests that money is not short-run neutral.
8.11 Classical models with real effects of money

In the standard classical model analysed above, money has no real effects. As mentioned
before, this is a pitfall of standard classical theory; money has been found to have real
effects at least in the short run. However, with some modifications to the reference
model, money can have real effects, even in models with perfectly flexible prices. These
are discussed below.
Lucas ‘misperceptions’ model
In the standard classical model every individual knows what the money supply is and
there is full and symmetric information about the state of the economy and about the
state of each market. Relaxing this assumption will allow money to have real effects.
Suppose an individual who produces goods in one market sees the price of his good
increasing due to an increase in demand. If that was caused by a relative demand shock
for his good (i.e. preferences changed so that the demand for his product increased
relative to some other goods) then it will be optimal for him to increase production,
essentially moving along his upward sloping marginal cost/supply curve. If, on the other
hand, the price rise was caused by an economy-wide increase in prices as a result of the
money supply increasing, then since nothing ‘real’ has changed, the demand for his
good has not altered relative to the demand for other goods, then it will be optimal for
him to leave output unchanged.
In reality, it will be unlikely that he knows the cause of the increase in price and so he
will opt for an intermediate strategy whereby he increases output by a little (not as
much as if he knew the price rise was caused by a relative demand shock but more than
if it was due to a monetary expansion, that being a zero output change). The Lucas
aggregate supply function is then given by (8.2).
yt = y ∗ + d(Pt − Et−1 [Pt ]) (8.2)
where yt is aggregate supply, y ∗ is the full employment/market clearing level of output
and Pt is the price level at date t.
At date t − 1, individuals make an expectation of the price level in date t, denoted
Et−1 [Pt ]. If the price level in date t is greater than expected, Pt − Et−1 [Pt ] > 0, agents
believe this is caused by a relative demand shock in date t, or by an increase in the
money supply that was unexpected. As a consequence, each individual/firm produces
more, which causes aggregate supply to increase above y ∗ . Hence d is positive and the
aggregate supply schedule is upward sloping rather than vertical. Also, an unexpected
increase in the money supply can have real effects even though prices are perfectly
flexible. People effectively ‘misperceive’ an increase in the price level as having been
107
caused by a relative demand shock, rather than an increase in the money supply. If the
monetary expansion was perfectly anticipated rather than unexpected, then everyone
would allow for this when making their expectation of Pt at date t − 1 and the
monetary expansion would have no real effects.4
Even though monetary policy has real effects in this set-up, the effects only persist in
the short run. In the long run, when people realise that the price rise is due to a
monetary expansion, output will revert back to its full employment level. This is true
not only of the Lucas misperceptions model but of all classical models that allow real
effects of monetary policy.
Cash in advance models
A problem with the money in utility (MIU) model is that it assumes people obtain
utility from something that is intrinsically useless. Adding money to the utility function
is then an odd way of introducing money. The cash in advance (CIA) model, however,
uses cleaner micro-foundations to explain the existence of money. It effectively tries to
model the trading frictions, such as the lack of trust between payer and payee discussed
in Chapter 2 that causes the trading process to necessitate a medium of exchange –
cash. People need cash in order to buy goods and sellers of goods will accept nothing
but cash when they trade. The trading round is assumed to be split into two periods.
In the first period individuals receive an income and decide how much of their wealth to
hold in cash and how much to hold in other forms such as bonds or capital that cannot
be used as a medium of exchange.
In the second period individuals buy and consume goods, facing the constraint that the
nominal value of their consumption must not be more than the nominal money holdings
they brought forward from the first period. Therefore, in addition to the budget
constraint, individuals face a ‘cash in advance’ constraint:
Pt Ct ≤ Mt−1 . (8.3)
Dividing by Pt−1 and noting that Pt /Pt−1 = 1 + πt , this can be written as:
(1 + πt )Ct ≤ mt−1 (8.4)
where mt−1 = Mt−1 /Pt−1 , and is equal to real money balances at date t − 1. (8.4)
implies that an increase in πt acts like an inflation tax; the consumers cannot purchase
in real terms the same amount of goods. Since their utility depends on consumption and
leisure, they will substitute (the now relatively more expensive) consumption goods for
leisure. That is, they will decrease their supply of labour due to the increase in inflation.
Thus employment, and therefore output, will decrease as a result of the increase in
inflation.
Limited participation models
Monetary policy can have real effects if there are a limited number of agents
participating in financial markets meaning some consumers may be restricted in their
4
See Chapter 9 and the section on the policy ineffectiveness proposition.
108
access to the banking system and therefore cannot save via interest bearing assets. If
the monetary authorities decided to increase the money stock, such policy actions would
be made through banks and other financial intermediaries with whom the open market
operations were conducted. Now faced with a glut of liquid assets, banks wish to lend
out some of these in order to maintain their desired reserve ratio. The increase in the
supply of loans will cause the interest rate charged on these loans to fall (the liquidity
effect) and since firms borrow from financial intermediaries to finance investment
projects, this makes investment cheaper. Cheaper investment causes investment to
increase, which therefore causes output, and employment if labour and capital are
complementary inputs, to increase.

describe how, in the classical economy, output is determined by the factor markets
describe and discuss the effects of monetary policy, with reference to the effects of
money on nominal variables such as prices and nominal wages, and on real
variables such as employment
describe what business cycle models are and what they try to do
list and explain the workings behind, the flexible price models where money has
real effects.

Section A
1. ‘According to the stylised facts of the business cycle, real wages, employment and
government spending are acyclical.’
Section B
2. Explain why money might be neutral in the long run but not in the short run.
3. Suppose the supply curve is given as in (8.2) and that aggregate demand is given
by: y = 1000 + 3(M/P ). Suppose there has been no shock in the economy for some
time and no changes in policy are expected in the near future. If M = 600, find y
and P in terms of y ∗ . What happens when the monetary authorities announce (in
advance) that M will increase to 650? What happens if this increase is entirely
unexpected? In this final part, you do not need to solve for P and y.
109
4. Suppose the economy of Myland is completely described by a cash-in-advance

model. However, for the population of Myland, leisure and consumption goods are
not substitutes in any way. The Governor of Myland decides to increase the money
supply in an attempt to expand the economy. Explain why this leaves output in
Myland unchanged.

Section A
1. The statement is false. Suggested answers should say that the real wage and
employment are both procyclical. A productivity shock, for example, will increase
labour demand, pushing up the real wage and increasing employment. With this
higher level of employment, more output can be produced, implying real wages and
employment are procyclical.
Section B
3. If the economy has not experienced any shocks for some time then Pt = Et−1 Pt and
hence, from (8.2), yt = y ∗ . If M = 600, then from the aggregate demand equation,
one can solve for P to obtain
1800
Pt = ∗ .
y − 1000
If the monetary authorities announce that the money supply at date t will be
M = 650, and if this announcement was made at or before date t − 1 (i.e. when
expectations of Pt were formed), then rational agents will change the prices they
charge on their goods in order to take this new money supply into account.
Expectations of Pt made at t − 1 will increase and again Pt = Et−1 [Pt ]. Again, from
(8.2), yt = y ∗ (i.e. the monetary expansion has no effect on output). From the
aggregate demand equation, we can solve for the price.
1950
Pt = .
y∗ − 1000
Note that the growth rate of the price level is equal to the growth rate of the
money supply. If the monetary expansion is entirely unexpected, then Et−1 [Pt ] will
not have changed, and will be equal to the original 1800/(y ∗ − 1000). The
monetary expansion will increase aggregate demand and this outward shift of the
demand curve along the supply curve of (8.2) will cause output to increase,
assuming δ 6= 0. Output increases and so does the price level, Pt . However, the
growth of the price level is less than that of the money supply, at least initially.
4. From the cash-in-advance model we know Pt Ct ≤ Mt−1 and as shown in (8.4), an

increase in inflation acts like a tax on consumption. The greater the inflation rate,
the lower the level of consumption is permitted for any level of real money
balances. Ordinarily, an increase in inflation that makes consumption more
expensive, would cause people to switch to more leisure, which is now relatively
cheap. However, if leisure and consumption are not substitutes in any way, then an
110
8.15. Appendix to Chapter 8: a ‘simple’ RBC model
increase in inflation, which still causes consumption goods to become more

expensive, will have no real effect on the work/leisure decision and so output in the
economy will not be affected.
8.15 Appendix to Chapter 8: a ‘simple’ RBC model

Please note that the material presented in this appendix is not examinable. Those who
do not wish to study this can move directly on to Chapter 9. For those who do wish to
follow and understand the model presented below, you may find it useful to consult the
following references.
Cooley, T. and G. Hansen ‘Money and the business cycle’, in Cooley, T. (ed.)
Frontiers of Business Cycle Research. (Princeton, N.J.; Chichester: Princeton
University Press, 1995) [ISBN 9780691043234].
Kydland, F.E. and E.C. Prescott ‘Time to build and aggregate fluctuations’,
Econometrica 50(6) 1982, pp.1345–370.
Lucas, R.E. Jr and N. Stokey ‘Money and interest in a cash-in-advance economy’,
Econometrica 55(3) 1987, pp.491–513.
A ‘simple’ RBC model with money in the utility
The model presented below is a simple RBC model. It is based on micro-foundations/

first principles whereby individuals, in a deterministic setting used here, choose today a
time path for consumption and other variables under their control in order to maximise
utility. We make the assumption that we live in a deterministic world (i.e. an economy
with no uncertainty) so that we do not need to worry about expectations of future
variables. This simplifies the notation and also means that we do not need to concern
ourselves with how expectations are formed. As such, the model presented is not strictly
in the true spirit of RBC theory but gives the reader a basic introduction to modelling
techniques so commonly used today.
Similar to the model of money in general equilibrium introduced in Chapter 5, the
representative agent derives utility from consumption goods, Ct , and real money
balances, Mt /Pt , but also from leisure, defined as 1 − lt where lt is labour supplied.
Utility is obtained from these variables not only today but into the future, discounted
at rate b. Assume a utility function of the form:
∞
X
t Mt
U= β ln Ct + ζ ln + γ ln(1 − lt ) (8.5)
t=0
P t
where ζ and γ are constant preference parameters. The individual maximises utility
subject to a budget constraint given in real terms in (8.6).
Mt Bt+1 Qt+1 Wt Mt−1 Bt
Ct + kt + + = lt + (1 + rt−1 )kt−1 + + . (8.6)
Pt Pt Pt Pt Pt
The constraint simply states that your consumption and asset holdings, left-hand side,
equal your income and assets brought over from last period, right-hand side. The
111
left-hand side comprises consumption, Ct , investment in capital, It (assume that the

capital stock you hold equals your investment made so kt = It , i.e. there is 100%
depreciation), Mt /Pt is real money balances and Bt+1 Qt+1 /Pt is savings, not in a
productive technology/capital, but in ‘discount’ bonds. Bt+1 is the number of bonds you
bought at date t that mature at date t + 1, paying one unit of money, one pound or one
dollar, for example. Since they are pure discount bonds, they pay no interest but are
bought at a price, Qt+1 , that is below 1, the maturity value. For example, a bond could
be bought today for £90 that pays £100 in one year’s time, effectively earning you an
interest rate of 11.1% (= (100 − 90)/90 × 100).5 Bt+1 Qt+1 is therefore the nominal value
of the bonds you purchase at date t. The budget constraint is in real terms so we divide
this quantity by the price level, Pt .
The right-hand side is your income and assets brought forward from last period.
(Wt /Pt )lt is the real income from your labour services. kt−1 was the capital invested at
date t − 1, which earns a total return of 1 + rt−1 , rt−1 being the real interest rate. Mt−1
was the amount of money you held at the end of date t − 1, divided by Pt in the budget
constraint to put it in real terms at date t. Finally, Bt is the number of bonds bought
that mature at date t, paying £1 or $1, etc. per bond. Hence we do not multiply by Q
since, by definition, the bond price at maturity is unity. Again, to put this in real terms
we divide by Pt in the budget constraint.
Agents then maximise (8.5) subject to (8.6) so we can form the Lagrangian, L. Note
that the budget constraint must hold in every time period so there is a Lagrange
multiplier for each time period, λt .
∞
X
t Mt
L = β ln Ct + ζ ln + γ ln(1 − lt ) (8.7)
t=0
Pt
∞
X Mt Bt+1 Qt+1 Wt Mt−1 Pt−1 Bt
+ λt Ct + kt + + − lt − (1 + rt−1 )kt−1 − · − .
t=0
Pt Pt Pt Pt−1 Pt Pt
Notice in the budget constraint we replace Mt−1 /Pt by (Mt−1 /Pt−1 ) · (Pt−1 /Pt ) so that
the numerator and denominator of real money balances are dated at the same time. The
individual’s choice variables are Ct , Ct+1 , Mt /Pt , lt , lt+1 , Bt+1 and kt . Table 8.1 lists the
choice variables and the first order conditions; derivatives of the Lagrangian with
respect to the choice variables set equal to zero.
5
See Chapter 9 for more discussion of bonds and interest rates.
112
Choice variable First order condition
βt
Ct Ct
+ λt = 0 (8.8a)
β t+1
Ct+1 Ct+1
+ λt+1 = 0 (8.8b)
Mt Pt
Pt
ζβ t M t
+ λt − λt+1 PPt+1
t
=0 (8.8c)
γβ t
lt − 1−l t
− λt Wt
Pt
=0 (8.8d)
t+1
lt+1 γβ
− 1−l t+1
− λt+1 Wt+1
Pt+1
=0 (8.8e)
Bt+1 λt QPt+1
t
1
− λt+1 Pt+1 =0 (8.8f)
kt λt − (1 + rt )λt+1 = 0 (8.8g)
Table 8.1
Fisher equation
From (8.8g), λt+1 /λt = 1/(1 + rt ). Also, (8.8f) implies λt+1 /λt = Qt+1 Pt+1 /Pt . If Qt+1 is
the price of a bond at date t that pays 1 unit of money at date t + 1, then
Qt+1 = 1/(1 + Rt ) where Rt is the nominal interest rate between t and t + 1. If inflation,
πt+1 , is defined as (Pt+1 − Pt )/Pt then Pt+1 /Pt = 1 + πt+1 . Combining the results from
(8.8f) and (8.8g) gives:
1 + Rt
1 + rt = ≈ 1 + rt − πt+1 for small Rt and πt+1 .
1 + πt+1
⇒ rt = Rt − πt+1 (the Fisher equation).
Consumption decisions
Dividing (8.8a) by (8.8b) results in

Ct+1 γt
=β = β(1 + rt ). (8.9)
Ct γt+1
(8.9) states that the growth rate of consumption is positively related to the real interest
rate and the extent to which we value future consumption shown by the discount factor,
β. If the real interest rate is high, we can forego one unit of consumption today to gain
113
a lot more consumption tomorrow. We will then postpone some of our consumption
until later, implying a high consumption growth rate.
Labour decisions
Dividing (8.8d) by (8.8a) gives:

Wt gCt
= . (8.10)
Pt 1 − lt
This is the labour supply curve used in the first part of this chapter. It essentially states
that the marginal rate of substitution between consumption and leisure, the ratio of
marginal utilities, is equal to the real wage. If the real wage is high, we will supply more
labour, lt . Dividing (8.8e) by (8.8d) and using (8.8g) implies:
1 − lt+1 Wt /Pt
= β(1 + rt ) . (8.11)
1 − lt Wt+1 /Pt+1
A high real wage today compared to tomorrow will cause individuals to supply more
labour today and less tomorrow. Knowing that you can earn more for any amount of
labour supplied now, you will forego some leisure time in order to work, the proceeds of
which can be used to buy even more consumption goods, increasing utility.
Activity 8.1 If a temporary productivity shock increases today’s real wage only,
this causes labour supply to increase today relative to tomorrow. What happens to
intertemporal labour supply decisions if there is a permanent productivity shock
that causes the real wage to increase today and in every future period?
Money holdings
Dividing (8.8c) by (8.8a) gives:

Pt C t λt+1 Pt
ζ =1− · . (8.12)
Mt λt Pt+1
Using the fact that λt+1 /λt = (1 + πt+1 )/(1 + Rt ) and Pt+1 /Pt = 1 + πt+1 , we can
rearrange (8.12) to get a money demand equation of the form:

Mt 1
= ζC1 1 + . (8.13)
Pt Rt
The demand for real money balances are positively related to consumption (transaction
demand) and the preference parameter, j, showing our preference for money compared
to consumption. Real money balances are also negatively related to the nominal interest
rate, Rt , as expected. Multiplying (8.12) by Mt /ζPt Ct gives:
Mt λt+1 Pt Mt
1= − · · . (8.14)
ζPt Ct λt Pt+1 ζPt Ct
Noting that λt+1 /λt = βCt /Ct+1 from (8.9) and cancelling terms results in:
Mt Mt+1 Mt
1= −b · . (8.15)
ζPt Ct ζPt+1 Ct+1 Mt+1
114
Let zt = Mt /ζPt Ct and Xt+1 = Mt+1 /Mt , (i.e. Xt+1 is the growth factor of the money
supply = 1 + mt+1 where mt+1 is the growth rate). For simplicity, assume that the
growth rate of money is fixed at m, implying Xt = Xt+1 = X.

β β β
zt = 1 + zt+1 = 1 + 1 + zt+2 . (8.16)
X X X
Substituting for future values of z and assuming zt+n does not explode for large n will
allow us to solve for zt as:
β β2
zt = 1 + + 2 + ···
X X
∞
X
n 1
⇒ zt = β . (8.17)
n=0
Xn
With X constant, this simplifies to zt = 1/(1 − β/X). Real money balances are then
negatively related to the growth rate of the nominal money supply, and so negatively
related to the inflation rate.
Activity 8.2 Using Xt+1 = 1 + µt+1 = Mt+1 /Mt and the fact that
Pt+1 /Pt = 1 + πt+1 , prove that in the steady state, when real money balances are
constant through time, the inflation rate, π, is equal to the growth rate of money, µ.
Production
Assume a Cobb-Douglas production function of the form yt = At kt−1 α

lt1−α . At is a time
varying productivity parameter and the source of the productivity shocks that cause the
business cycle. Notice that yesterday’s capital stock, kt−1 , determines today’s output
(i.e. we invest in one period and it only pays off in the next). This is consistent with the
way capital enters the budget constraint, (8.6). Firms are assumed to maximise real
profits, which are real revenues, output, minus the real costs of employing labour and
capital (i.e. firms face the problem):
Wt
max Πt = yt − lt − rt−1 kt−1
Pt
α
s.t. yt = At kt−1 lt1−α
α Wt
⇒ max Πt = At kt−1 lt1−α − lt − rt−1 kt−1 . (8.18)
Pt
Differentiating this with respect to the two choice variables, lt and kt−1 , shows us that
the marginal cost of capital, rt−1 , will equal its marginal product. The marginal cost of
labour, Wt /Pt , will similarly equal its marginal product.
α−1 1−α
rt−1 = αAt kt−1 lt (8.19)
Wt α
= (1 − α)At kt−1 lt−α . (8.20)
Pt
115
Model solution
In order for us to solve this RBC model, deriving solutions for Ct , kt , lt and yt , we first
have to impose the resource constraint that output equals consumption plus investment.
This basically states that what is produced is either consumed or put back into the
economy to produce goods next period. Since we assume 100% depreciation, investment,
It , must equal the capital stock, kt , that is used in the production of tomorrow’s goods.
y t = C t + kt . (8.21)
We also have to note that individuals face two forms of saving devices, capital and
bonds, the real returns from which must be equal in order to avoid infinite arbitrage
opportunities that are clearly inconsistent with the real world. One unit of capital at
date t will yield rt units at date t + 1. On the other hand, one bond costing Qt+1 units
of money at date t will pay 1 unit of money at date t + 1. We can convert this into real
terms by dividing each date by its respective price level so that Qt+1 Pt+1 /Pt units of
goods saved in bonds at date t will yield 1 unit of consumption good at date t + 1. If
the price level rose between dates t and t + 1 then the real return on bonds will be lower
since more consumption goods have to be put into bonds at date t in order to get one
unit at date t + 1. This is shown more clearly in Table 8.2.
Date t Date t + 1
Capital 1 rt
Bonds Qt+1 Pt+1 /Pt+1 1
Table 8.2
This implies that there is a relationship between the returns to capital and bonds that
satisfies the following:
Qt+1 Pt+1
rt = 1. (8.22)
Pt
Using the fact that Qt+1 Pt+1 /Pt = lt+1 /lt = βCt /Ct+1 and substituting rt from (??) will
give us:
βCt
αAt+1 ktα−1 lt+1
1−α
= 1. (8.23)
Ct+1
Using (8.23), the resource constraint, (8.24), and labour market clearing, (8.25), we will
be able to solve for current and future values of C, k, l and y if we impose an initial
condition for k0 .
α
Ct + kt = At kt−1 lt1−α (8.24)
γCt
α
(1 − α)At kt−1 lt−α = . (8.25)
1 − lt
116
Notice that in (8.23) to (8.25) there are no nominal quantities, Q, W , M or P .

Therefore a change in M , for example, will not have any effect on any of the real
variables, C, k, l or y. Money is neutral. In the sense that (8.23) to (8.25) do not
depend on the growth rate of money, money can be argued to be superneutral.
However, real money balances do depend on the growth rate of money as demonstrated
in (8.17) so, strictly speaking, money is not superneutral. Since utility depends
positively on real money balances, an increase in the growth rate of money that reduces
real money holdings will have detrimental effects on welfare.
Activity 8.3 For the more interested student, show that the solution to (8.23) to
(8.25) is:
−1
1 − αβ α g(1 − αβ)
Ct = kt , kt = αβAt kt−1 lt1−α , lt = 1+ .
αβ 1−α
Outline of answer
From (8.23):
1−α
Ct /kt At+1 ktα lt+1 Ct /kt Ct+1 + kt+1
1 = αβ · = αβ · .
Ct+1 /kt+1 kt+1 Ct+1 /kt+1 kt+1
Using the resource constraint, this implies:

kt kt+1
= αβ +1 .
Ct Ct+1
Solving forward for kt+1 /Ct+1 , noting that |αβ| < 1 and assuming that kt+n /Ct+n
does not explode will give kt /Ct = αβ/(1 − αβ), from which we obtain the solution
for Ct . Substitute this into the resource constraint and solving for kt gives us the
second part of the solution that tells us how kt evolves over time. Using the resource
α
constraint to substitute out At kt−1 lt1−α in (8.25) and substituting Ct from the first
part of the solution will give us the solution for lt .
117
118
Chapter 9
Keynesian models with money supply
as a policy instrument
9.1 Introduction
In the last chapter we examined the effects of monetary policy and saw that frictions in
the classical model (in the form of asymmetric information, the requirement to hold
cash before you could buy, and limited participation in financial markets) all led to
money having real effects. Here, we will examine one particular type of friction, namely
the friction to prices. If prices, of goods or of labour, are sticky then changes in the
money supply will cause changes to real money balances and/or to the real wage. A
change in the stock of nominal money will then have consequences in the real economy.
Despite some of these models being thought up and refined in the latter years of the
20th century, we put such models of nominal rigidities under the umbrella of ‘Keynesian
models’, the term that is usually used when referring to them.
9.2 Aims
This chapter aims to introduce models with nominal (price) frictions where the
monetary policy instrument is a monetary aggregate. We find short-term real effects of
monetary policy under certain conditions.

explain the importance of nominal rigidities and why such sticky prices occur in
the real world
examine the effects of monetary policy in the short and long run when there are
nominal rigidities
describe the workings of the Phillips curve and augmented Phillips curve, noting
the differences between the two
build and work through models of sticky prices, examining the effects of monetary
policy
119
9. Keynesian models with money supply as a policy instrument
explain why multi-period pricing can lead to real and persistent effects of monetary
policy
discuss the merits of various sticky price models, noting, in particular, the different
short-run and long-run effects of monetary policy.
9.4 Reading advice

The content of this chapter, especially the latter half, is based primarily on McCallum
(1989), Chapters 9 and 10, and it is recommended that you read these chapters while
working through this section. However, before doing so you should refresh your memory
with the Keynesian macroeconomic models, found in all macro textbooks. (see for
example Mankiw (2002) or Branson (1989)).
The review article by Phelps in the New Palgrave Dictionary of Money and Finance is
also very good and should be read after completing this chapter. The article by
Blanchard is thorough but difficult and should only be read when you feel comfortable
with the material here and in the other readings. For empirical evidence of nominal
rigidities, see Gordon.

Gordon, R.J. ‘A century of evidence on wage and price stickiness in the US, the UK and
Japan’, in Tobin, J. (ed.) Macroeconomics, Prices and Quantities. (Oxford: Blackwell,
1983).
Hargreaves Heap, S.P. The New Keynesian Macroeconomics: Time, Belief and Social
Independence. (Edward Elgar Publishing, 1992) Chapters 5 and 6.
Macmillan, 1989) Chapters 9 and 10.
Phelps, E.S. ‘Phillips curve’, in Newman, P., M. Milgate and J. Eatwell (eds) The New
9.6 Further reading

Books
Blanchard, O.J. ‘Why does money affect output? A survey’, in Friedman, B. and F.
Hahn (eds) Handbook of Monetary Economics. (Amsterdam: North-Holland, 1990).
Branson, W.H. Macroeconomic Theory and Policy. (New York; London: Harper and
Row, 1989).
Phelps, E.S. Microeconomic Foundations of Employment and Inflation Theory. (New
York: Norton, 1970).
120
9.7. Keynesian aggregate supply function
Rotemberg, J.J. and M.Woodford ‘Dynamic general equilibrium models with

imperfectly competitive markets’, in Cooley, T. (ed.) Frontiers of Business Cycle
Research. (Princeton, N.J.; Chichester: Princeton University Press, 1995).
Journal articles
Friedman, M. ‘The role of monetary policy’, American Economic Review 58(1) 1968,
pp.1–17.
Phillips, A.W. ‘The relation between unemployment and the rate of change of money
wage rates in the United Kingdom’, Economica 25(100) 1958, pp.283–99.
9.7 Keynesian aggregate supply function

An early model of nominal rigidities was that of sticky nominal wages. Labour unions
were argued to negotiate wages on a yearly basis, which would not allow nominal wages
to adjust instantaneously to changes in market conditions. As in Chapter 8, output is
produced from capital and labour, and firms employ workers up to the point where the
marginal product of labour is equal to the marginal cost, the real wage. However, unlike
in classical models, labour employed, and hence output produced, only depends on
labour demand (not on the intersection of demand and supply!). Firms are assumed to
have the ‘right to manage’, whereby firms can choose how much labour to employ, even
if this is more than the amount workers wish to supply at the going real wage. This
could happen, for example, by firms asking, or forcing, labour to work overtime.
Similarly, if the demand for labour by firms was below that which workers wish to
supply, this will result in unemployment.1
The aggregate supply curve in the economy is then going to be upward sloping. If the
nominal wage is fixed at W ∗ , an increase in the price level will cause the real wage,
W ∗ /P , to fall, resulting in higher labour demand. More labour employed (if firms have
the right to manage) will lead to more output supplied, implying an upward-sloping
aggregate supply schedule. However, in the long run, wages will be renegotiated to the
market clearing level, at which point employment, output and other real variables are
determined by tastes and technology, not the price level. The long-run aggregate supply
schedule is then vertical as in Chapter 7.
The effect of monetary policy
The effect of monetary policy can best be shown by using a similar set of diagrams to
those of Figure 8.2. This is shown, for sticky nominal wages, in Figure 9.1. The middle
left panel shows the labour market when the nominal wage is fixed at W ∗ and the
bottom left panel shows the standard production function with diminishing marginal
returns to labour. The top right diagram shows the IS–LM curves and the middle right
panel shows aggregate demand and supply. Note that aggregate supply is upward
sloping as explained above.
1
Note that the ‘right to manage’ is not needed where the real wage is above the market-clearing wage
rate.
121
Figure 9.1:
122
Expansionary monetary policy causes the aggregate demand schedule to shift out and
also causes the LM curve to shift to the right. Since the AD shift causes a price rise,
this will tend to reduce real money balances, causing a partial offsetting of the outward
LM shift. As in the analysis in Chapter 8, a monetary expansion causes the labour
demand curve to shift out. The increase in the price level reduces the real wage for any
given nominal wage, leading to an increase in labour demand. However, since the
nominal wage is fixed, and given the ‘right to manage’ assumption, firms employ more
labour so that employment increases to l00 and output increases to y 00 . A monetary
expansion therefore has real effects caused by nominal wages being sticky. In the long
run, however, the nominal wage will be bid up as workers renegotiate their contracts to
counter the fall in their real wage. In the long run, employment will remain at l0 , output
will remain at y 0 and the monetary expansion simply causes a one-for-one movement in
prices and nominal wages.2
The Phillips curve
The assumption of sticky nominal wages can easily explain the short-run real effects of
monetary policy. However, this implies that the real wage is strongly countercyclical;
clearly inconsistent with empirical findings. Also, despite the ability of the above model
to explain the existence of unemployment, it sheds very little light on to the mechanism
by which wages are determined. If wages are predetermined in the current period, then
changes in the economy must be reflected in wages in the next period. This is not
explicitly modelled above, but was the focus of research made by Phillips (1958).
Phillips overcame the problem of assuming exogenously fixed wages by assuming that
the nominal wage depends on recent values of unemployment. This assumption was
based on an empirical regularity between unemployment and nominal wage inflation in
the UK from 1861 to 1957. This is shown in Figure 9.2.
Intuitively, if unemployment was high, trade unions, and labour in general, could not
negotiate larger pay increases since firms would have a large pool of unemployed with
which to fill its vacancies. When unemployment is high, labour tends to be in a weak
bargaining position. The specification Phillips gave for the relationship was:
ln Wt = ζ(ut−1 ) + ln Wt−1
⇒ ∆wt = ζ(ut−1 ) with ζ 0 < 0 (9.1)

where wt is the log of the nominal wage, = ln Wt , and ∆ denotes the first difference
operator. Firms that maximise profits will set the marginal product of labour equal to
the real wage, Wt /Pt , which implies that an increase in the nominal wage will be
associated with an increase in the price level. ∆wt and ∆pt will be highly correlated,
with the result that (9.1) can be written as:
∆pt = ζ(ut−1 ) with ζ 0 < 0. (9.2)
The relationship states that there is a permanent trade-off between inflation and
unemployment. It appeared that all policy makers had to do to lower unemployment
2
The increase in the price level from P1 to the long-run equilibrium of P2 should cause the labour
demand and supply schedules to shift up from I1d and I1s but this is ignored here as it would simply
complicate the diagram.
123
Figure 9.2:
and increase output was to allow inflation to rise. However, in the 1970s the Phillips
curve relationship broke down and this was explained, and indeed predicted, by
Friedman (1968) and Phelps (1970) who emphasised the importance of inflation
expectations, which had been ignored thus far.
Augmented Phillips curve
Friedman and Phelps claimed that agents cared, not about their nominal wage, but
about how many goods such a wage could buy (i.e. what really mattered was their real
wage). By augmenting (9.1) with inflation, ∆pt , unemployment in period t − 1 would
determine changes in real wages. This is shown in (9.3).
∆wt − ∆pt = ζ(ut−1 ). (9.3)
However, since there is no current information about ∆pt (inflation is only realised after
nominal wages have been negotiated), this has to be anticipated. If ∆pet is the
expectation formed at date t − 1 of inflation at date t, then the expectations-augmented
Phillips curve can be written as:
∆wt = ζ(ut−1 ) + ∆pet with ζ 0 < 0. (9.4)
The expectations augmented Phillips curve explained the breakdown of the simple
version that occurred in the 1970s. There were argued to be a number of short-run
Phillips curves, one for each level of expected inflation. Unexpected inflation would
move you along a given short-run Phillips curve but in the long run there would be no
trade-off between unemployment and inflation. As people’s expectations of inflation
increased to meet actual inflation we would move to another short-run Phillips curve. In
124
equilibrium, when inflation was equal to expected inflation, unemployment would be

constant at its natural rate. In the long run, any attempt to reduce unemployment to
below its natural rate would simply be inflationary. The reason the Phillips curve broke
down was because of the persistent and high inflation of the 1970s, caused partly by
policy makers trying to exploit the Phillips curve to reduce unemployment and partly
by the supply side shocks in the form of large oil price rises in 1974. The high inflation
caused expectations of inflation to increase, causing the existing ‘stable’ Phillips curve
to shift. In the period 1861 to 1957, although there were periods of notable price rises
and falls, inflation, and therefore expected inflation, was on the whole rather stable.
Okun’s law
As can be seen in Figure 9.1, there is somewhat negative relationship between

unemployment and departures of output from potential, y ∗ . This is known as Okun’s
law, which can be applied to the Phillips curve to transform (7.4) into:
∆pt = γ(yt − y ∗ ) + ∆pet with γ 0 > 0
1
⇒ yt = y ∗ + (∆pt − ∆pet ). (9.5)
γ
This is the same as the Lucas aggregate supply curve, where d = 1/g and we have
replaced unanticipated prices by unanticipated inflation. Note, however, that even
though both Lucas model and Okun’s law have similar predictions (real effects of
unanticipated monetary policy caused by an upward-sloping aggregate supply curve),
they have different microfoundations. The Lucas supply curve is based on imperfect
information on the sources of good specific price changes that affects real output and
employment fluctuations are voluntary, whereas the Phillips curve assumes nominal
rigidities that leads to involuntary employment fluctuations.
Menu costs and sticky prices
We now outline a model of sticky prices in the goods market. Prices are set at the
beginning of the period and cannot change to accommodate shocks or other
developments in the economy. As employment was demand determined at the start of
this chapter in the case of sticky wages, output is demand determined in this situation
of sticky goods prices. Firms produce as much as is demanded at the price that was set
at the beginning of the period, even if this means supplying more than they would
ordinarily wish to produce given those market conditions.
Activity 9.1 Why would a firm want to produce at a level that is demand
determined? (Hint: think of the relationship between customers and producers!)
How can we justify the assumption of sticky prices? If, after setting a price, market
conditions change, why do firms not change their prices to accommodate such
developments and thus maximise profits? There are a number of theories to rationalise
sticky prices. Two common arguments are the existence of menu costs and the attempts
by firms not to disturb the loyal customer base with frequent price changes. If prices do
125
change frequently, a number of repeat customers may look elsewhere in the market.
Prices may then be kept constant in order to keep these valuable customers happy.
Menu costs, on the other hand, refer to the costs that firms face when they change their
list prices. Such costs arise due to the need to issue updated catalogues, for example. It
should then not be that unreasonable to assume that prices are, to a greater or lesser
extent, inflexible.
Activity 9.2 What industries can you think of that have very sticky prices? Which
industries have very flexible prices?
A model of sticky prices
This model is taken from McCallum (1989), Chapter 10, and you are strongly
recommended to read this chapter while working through what follows. First consider
aggregate demand. By combining the IS and LM equations, we can derive an AD
expression of the form:
yt = β0 + β1 (mt − pt ) + β2 Et−1 [pt+1 − pt ] + vt . (9.6)
yt , mt and pt are the logs of real output, nominal money balances and the price level,
respectively, at date t. vt is a random demand shock with zero mean (i.e. an element of
aggregate demand that is not picked up by real money balances or expected inflation).
β0 , β1 and β2 are positive parameters and Et−1 is the rational expectations operator
with the t − 1 subscript denoting the date the expectation was formed. In rational
expectations, people not only take all available information into account when they
form their expectations, but their expectations are also consistent with the way in
which the variables actually evolve. Rational expectations are sometimes also known as
‘model consistent’ expectations.3 The equation states that aggregate demand depends
positively on real money balances and positively on expected inflation; for any given
nominal interest rate, higher inflation implies a lower real interest rate, making
investment cheaper.
Aggregate supply is a little more difficult to specify because of the assumption that
prices are set at the beginning of the period, with supply being demand determined.
Denote the price that clears the market at date t as p∗t . Where is the price stickiness in
the model coming from? We assume that the prices the firms set at date t − 1, to be
operational in the market at date t, pt , are the prices they expect to clear the market at
date t, i.e.:
pt = Et−1 [p∗t ]. (9.7)
As in time t − 1, shocks are unknown, these cannot be taken into account when setting
the prices. Also, denote the output level that clears the market at date t as yt∗ . Then, if
the price equals that which allows markets to clear, by definition markets must clear
and so yt∗ must equal the demand when pt = p∗t .
yt∗ = β0 + β1 (mt − p∗t ) + β2 Et−1 [pt+1 − p∗t ] + vt . (9.8)

3
You should refer for a refresher on rational expectations to work with expectations operators. Also,
see Branson (1989), Chapter 11.
126
Rearranging (7.8) to obtain p∗t on the left-hand side gives:
β0 − yt∗ + β1 mt + β2 Et−1 [pt+1 ] + vt

p∗t = (9.9)
β1 + β2
noting that Et−1 [p∗t ] equals pt from (9.7) and that in the situation of market clearing,
pt = p∗t . We now need an expression telling us how the market clearing/full employment
level of output, yt∗ , evolves over time. Here we will generalise the process used in
McCallum (1989) so that yt∗ increases gradually through time but also depends
positively on last period’s full employment output level, which allows persistence of full
employment output. If full employment output is high today, it is likely to be high
tomorrow.
yt∗ = δ0 + δ1 t + δ2 yt−1
∗
+ ut . (9.10)
ut is a zero mean, random supply, shock, which could include the discovery of oil
reserves or other raw materials or a sudden technological breakthrough that can
increase the productive capacity of the economy.
Activity 9.3 Consider expressions for yt∗ of the form, i. yt∗ = δ0 + δ1 t + ut and ii.
yt∗ = yt−1
∗
+ δ0 + ut . What are the differences between these two processes? (Hint:
what is the persistence of the shock, ut , in both equations; how long does the shock
last?)
(9.7), (9.9) and (9.10) together can be regarded as constituting aggregate supply. Along
with aggregate demand, (9.6), we can solve for the output level, yt , in terms of
deviations from yt∗ , and also for the price level, pt . The solution method is given in
McCallum, Chapter 10, and you should read the relevant section in order to see how the
solution is derived. However, a brief outline is given below.
Take expectations of (9.10) conditional on information available at date t − 1:
Et−1 [yt∗ ] = δ0 + δ1 t + δ2 yt−1

∗
⇒ Et−1 [yt∗ ] = yt∗ − ut . (9.11)
Do the same for (9.8), noting that Et−1 [vt ] = 0:
Et−1 [yt∗ ] = β0 + β1 Et−1 [mt − p∗t ] + β2 Et−1 [pt+1 − p∗t ]. (9.12)
Equating (9.11) and (9.12), noting that Et−1 [p∗t ] in (9.12) is equal to pt (from (9.7))
gives:
yt∗ = β0 + β1 (Et−1 [mt ] − pt ) + β2 (Et−1 [pt+1 ] − pt ) + ut . (9.13)
If we subtract (9.13) from (9.6), we will have an expression for yt − yt∗ (i.e. deviations of
output from the market clearing level).
yt − yt∗ = β1 (mt − Et−1 [mt ]) + vt − ut . (9.14)
127
Monetary policy
Imagine that the money supply set by the authorities changes according to:
mt = µ0 + µ1 mt−1 + et (9.15)
where et is a zero mean, random error representing monetary policy shocks. Taking
expectations of (9.15) conditional on information at date t − 1 will give us an expression
for the unexpected money supply at date t, mt − Et−1 [mt ], which simply equals et .
Substituting this into (9.14) will give us a solution for the output deviation, yt − yt∗ .
yt − yt∗ = β1 et + vt − ut . (9.16)
Notice that the systematic component of monetary policy (µ0 + µ1 mt−1 ) does not have
any real effects here. This is because at date t − 1, when prices for date t are set, firms
take into consideration what they expect the monetary authorities will do. If they
expect the money supply to increase, knowing that money should have no real effects,
they will increase their prices for date t accordingly. Only the random component of
monetary policy, the monetary policy shock et , will have real effects since this is realised
after the prices have been set. This result, that the systematic component of monetary
policy has no real effect, will be discussed in more detail in the next section ‘policy
ineffectiveness proposition’.
Activity 9.4 What happens if the monetary authorities react to last period’s
∗
output deviation, in other words, if we add µ2 (yt−1 − yt−1 ) to the monetary policy
rule (9.15)? Explain your results.
Why would the monetary authorities want to respond to lagged deviations in the
first place?
The fact that unanticipated monetary policy, in the form of the shock, et, has real
effects, is essentially because prices are fixed for one period. Prices are set at date t − 1
for the market at date t. Any event occurring, relevant for the market at date t, after
prices have been set will naturally be reflected in real variables such as output and
employment. Now consider what happens when prices are set for two periods. The
model of multiperiod pricing, again from McCallum, Chapter 10, will be used to analyse
the effects of monetary policy in this setting.
Multi-period pricing
Let there be two types of firms, ‘A’ firms and ‘B’ firms. Both set prices for two periods,
but at different times. At date t − 2 (based on the information available at that date)
‘A’ firms set, possibly different, prices for the market at dates t − 1 and t. ‘B’ firms also
set prices for two periods but do so a period later (i.e. at date t − 1 they set prices for
the market at dates t and t + 1). This is shown more clearly in Figure 9.3.
At date t − 2, ‘A’ firms set their prices (for the market at t − 1 and t) at the level they
expect will clear the market. ‘B’ firms set their prices at date t − 1 for t and t + 1
similarly. Therefore, at date t, the price level will be the average of the prices set by ‘A’
128
Figure 9.3:
firms and by ‘B’ firms. This is just the average of prices set by ‘A’ and ‘B’, conditional
on the information available at the time they were set.
Et−1 [p∗t ] + Et−2 [p∗t ]
pt = . (9.17)
2
To solve the model, we simplify the aggregate demand function by setting β2 = 0, i.e.
yt = β0 + β1 (mt − pt ) + vt . Also, assume that the market clearing output level, yt∗ ,
follows the process given by yt∗ = d0 + d1 t, i.e. yt∗ is purely deterministic, subject to no
shocks. Using the methods outlined above, aggregate demand will equal the market
clearing level of output when the price is equal to that which clears the market, pt = p∗t .
yt∗ = β0 + β1 (mt − p∗t ) + vt . (9.18)
Taking expectations of (9.18) conditional on information available at t − 1 and t − 2 will
give:
Et−1 [yt∗ ] = β0 + β1 Et−1 [mt − p∗t ] (9.19)
Et−2 [yt∗ ] = β0 + β1 Et−2 [mt − p∗t ].

Averaging these two expressions, noting that Et−1 [yt∗ ] = Et−2 [yt∗ ] = yt∗ from the fact
yt∗ = δ0 + δ1 t, gives us:
1 1
yt∗ = β0 + β1 · (Et−1 [mt ] + Et−2 [mt ]) − β1 · (Et−1 [p∗t ] + Et−2 [p∗t ]) . (9.20)
2 2| {z }
pt
Subtracting (7.20) from the expression for aggregate demand results in:
1 1
yt − yt∗ = β1 · (mt − Et−1 [mt ]) + β1 · (mt − Et−2 [mt ]) + vt . (9.21)
2 2
Let monetary policy be the same as before:
mt = µ0 + µ1 mt−1 + et = µ0 + µ1 (µ0 + µ1 mt−2 + et−1 ) + et . (9.22)
129
In order to find an expression for Et−2 [mt ], for us to solve (7.), we need to write mt in
terms of variables that we know at date t − 2. Hence we replace mt−1 by backward
substitution. As before, we take expectations of mt conditional on information available
to us at t − 1 and t − 2 and we can find that:
mt − Et−1 [mt ] = et
mt − Et−2 [mt ] = µ1 et−1 + et . (9.23)

∗
Substituting these expressions into (9.21) will give us our solution for yt − yt−1 .
1
yt − yt∗ = β1 et + β1 µ1 et−1 + vt . (9.24)
2
This is the main result of the assumption of multi (two)-period pricing. A shock to the
supply of money, et−1 , not only has real effects at date t − 1, but also in the following
period, t. The reason why it affects output at t − 1 should be clear; prices for the
market at date t − 1 were set at t − 2 (‘A’ firms) and t − 3 (‘B’ firms) so a shock at date
t − 1 will cause output to change at t − 1. However, once the shock has been realised,
only ‘B’ firms can take this into account when they set period t prices (see Figure 7.3).
‘A’ firms cannot take et−1 into consideration since their period t prices were set at date
t − 2. Since not all firms can change strategies after the realisation of new market
conditions, the shock at date t − 1 will have real effects at date t. With multi-period
pricing, monetary shocks can have real and, more importantly, persistent effects. The
more periods for which a firm sets its prices, the longer and more persistent any
monetary shocks will be. Not only that, but also the output deviation, yt − yt∗ , now
depends on the parameters of the monetary policy rule, m1 . The systematic component
of monetary policy now has real effects (by determining the persistence of any shocks)
although the choice of the m parameters will not cause permanent deviations of output
from y ∗ . Money, in the long run, is still neutral.
9.8 Predictable and unpredictable components of the

money supply
The monetary authorities react to events in the economy; if inflation is high in one
period, the authorities may reduce the money supply in an attempt to reduce the
undesired inflation. Alternatively, the current money stock may be dependent on past
output, unemployment, lagged money supplies, and so on. One can call the part of the
money stock that depends on these variables the predictable component of monetary
policy, since the monetary authorities change the stock of money ‘systematically’ with
the observed economic variables known to them when they make their policy choice.
The remainder of the money supply can be considered as a monetary shock, either
originating from the authorities themselves or in the financial markets, if for example
there was a change in the public’s desired currency-deposit ratio that affects the money
multiplier (see Chapter 4).
The money supply in the last chapter (Lucas misperceptions model) followed a process
of the form:
mt = µ0 + µ1 mt−1 + et (9.25)
| {z } |{z}
predictable component monetary shock
130
9.8. Predictable and unpredictable components of the money supply
We assume that the monetary shock is purely random/white noise and so our best
guess of it before it is realised, Et−1 [et ], is its unconditional mean, zero. Under the
assumption of rational expectations, the expectation of mt , based on information
available at date t − 1, will be given by:
Et−1 [mt ] = µ0 + µ1 mt−1 . (9.26)
For simple models, where the monetary authorities and the public share the same
information sets, the expected money supply will simply be the predictable component
and the unpredictable component of the money supply will be the monetary shock, et .
Policy ineffectiveness proposition (PIP)
As we saw in the previous chapter, monetary shocks have real effects in the economy
while changes in the predictable component of monetary policy do not change output at
all. This is because people can change their prices in anticipation of the change in
policy. Whereas the model in the previous chapter assumed sticky prices in order for
monetary shocks to have real (short-run) effects, one can easily use the Lucas supply
curve model to obtain a similar result for flexible price economies.
Activity 9.5 Assume aggregate demand is given by yt = β0 + β1 (mt − pt ) + vt and

aggregate supply is given by yt = y ∗ + α(pt − Et−1 [pt ]). If monetary policy follows the
rule of (9.25), show that the predictable component of monetary policy has no real
effects.
(Hint: to answer this, equate AD and AS and bring all terms in pt only over to the
left hand side. Take expectations of this conditional on date t − 1 information and
hence obtain an expression for pt − Et−1 [pt ] in terms of mt , Et−1 [mt ], etc. Substitute
this expression into the AS function and use (9.26) to solve for yt − y ∗ .)
So even when prices are perfectly flexible, monetary shocks can have real effects, caused
by the asymmetric information assumption of the Lucas model. The predictable
component of monetary policy, showing how the authorities change the money supply
depending on the state of the economy, has no effect at all on real variables. This is the
policy ineffectiveness proposition (PIP). A policy of the form mt = µ0 + et will have the
same effect on the economy as when money depends on lagged money, inflation, output,
and so on.
Rational expectations models and PIP
When proving that PIP holds in the sticky price and Lucas models, we assumed that
agents had rational expectations when forming estimates of future variables. Hence the
mt − Et−1 [mt ] term which enters the output equation can be replaced by et , the
monetary shock. It may appear that the only reason that PIP holds is because of the
assumption of rational expectations. However, PIP does not hold in all rational
expectations, RE, models. Consider the aggregate demand function in (9.27).
yt = β0 + β1 (mt − pt ) + β2 Et [pt+1 − pt ] + vt . (9.27)
131
This is exactly the same as (9.6) in the sticky price model, only the expectation of
inflation is made at date t, not t − 1. When making similar assumptions as before,
pt = Et−1 [p∗t ] and yt∗ = d0 + d1 t, we can show that yt∗ can be given by:
yt∗ = β0 + β1 (mt − p∗t ) + β2 Et [pt+1 − p∗t ] + vt . (9.28)
Taking expectations of (9.28), conditioning on t − 1 information, noting that

Et−1 [yt∗ ] = yt∗ and that Et−1 [Et [p∗t ]] = Et−1 [p∗t ], from the law of iterative expectations
(see for example, Branson (1989) Chapter 11), which equals pt , then we obtain:
yt∗ = β0 + β1 (Et−1 [mt ] − pt ) + β2 (Et−1 [pt+1 ] − pt ). (9.29)
Subtracting (9.29) from the aggregate demand equation, (9.27), will give us an
expression for the output deviation, yt − yt∗ .
yt − yt∗ = β1 (mt − Et−1 [mt ]) + β2 (Et [pt+1 ] − Et−1 [pt+1 ]) + vt . (9.30)
The monetary shock term, mt − Et−1 [mt ], enters as before, but a change in the
predictable component of monetary policy could indeed alter people’s expectations of
tomorrow’s price level. If a change in the predictable component of monetary policy
causes a change in expectations (between dates t − 1 and t) of pt+1 , then PIP no longer
holds even though rational expectations are assumed. Monetary policy can then have
real effects, but again only in the short run. Prices are set at date t − 1 for date t and so
can only contain information available up until date t − 1. Aggregate demand, on the
other hand, depends on the expectation of inflation made at date t (relevant for
investment decisions through the Fisher equation). Firms, setting their prices at the
level they expect to clear the market, have to make an expectation of this term but do
so at date t − 1. The fact that expected inflation can rise with new information means
aggregate demand can be greater than firms initially anticipated, causing output to
increase.
Lucas critique
The Lucas critique refers to the instability of reduced-form expressions used for policy
making or policy appraisal. In the sticky price model of the previous section, the
structural equations were given by the aggregate demand equation, the price equation,
pt = Et−1 [p∗t ], the equation showing how yt∗ evolves and the monetary policy reaction
function showing how mt depends on the state of the economy. When we solve for
yt − yt∗ , the equation we derive is a reduced-form equation; a mixture of aggregate
demand, aggregate supply and the authorities’ reaction function. For example, consider
the sticky price model and the reduced-form expression, (9.16), yt − yt∗ = β1 et + vt − ut .
Instead of et , write mt = Et−1 [mt ] = mt − µ0 − µ1 mt−1 .
yt − yt∗ = −β1 µ0 + β1 mt − β1 µ1 mt−1 + (vt − ut ). (9.31)
If this equation were given to an econometrician, he or she would run a regression of the
form:
yt − yt∗ = γ0 + γ1 mt + γ2 mt−1 + η1 (9.32)
and would find a positive coefficient for γ1 since we know γ1 = β1 (only if the economy
was accurately represented by the structural equations given above!). Since γ1 > 0, we
132
may then think that an increase in the money supply should cause an increase in output
above yt∗ . For example if γ1 was found to equal 0.5, then increasing the money supply by
2% should cause a 1% increase in output. However, as we saw in the earlier section, the
predictable component of monetary policy had no real effects. Even though we may
think an increase in the money supply will increase output (from the reduced form
equation, (9.32)), in reality the change in people’s expectations associated with this
policy change will cause the reduced form to break down. If the authorities increased
the money supply by increasing µ0 , indeed this will have a positive effect on output, via
γ1 , but it will also have a negative effect on output since γ0 = −β1 µ0 . The effect of an
expansionary monetary policy will be purely inflationary. Quoting Romer (2001) p.251,
‘If policy makers attempt to take advantage of statistical relationships, effects

operating through expectations may cause the relationships to break down.
This is the famous Lucas critique.’

explain the importance of nominal rigidities and why such sticky prices occur in
the real world
examine the effects of monetary policy in the short and long run when there are
nominal rigidities
describe the workings of the Phillips curve and augmented Phillips curve, noting
the differences between the two
build and work through models of sticky prices, examining the effects of monetary
policy
explain why multi-period pricing can lead to real and persistent effects of monetary
policy
discuss the merits of various sticky price models, noting, in particular, the different
short-run and long-run effects of monetary policy.

Section A
1. ‘The assumption of rational expectations implies that agents know that prices are
flexible.’
133
Section B
2. If prices are sticky, what happens to the short-run Phillips curve after an increase
in expected inflation?
3. Why, in Taylor’s relative price theory, can changes in money induce permanent
deviations of output from its flexible price level?
4. Suppose that recent economic indicators suggest that although output is growing
at 3.5% per year, inflation is at 4% per year, up from 3% last year. If someone asks
you to forecast the effect of this new inflation data, what would be your response?
(Hint: make sure you specify what model you are using, what variables you are
considering and what kind of real effects you forecast. Also mention if you expect
any of the stylised facts of the business cycle to occur.)
5. Suppose that you know that the full employment level of output in England is
y = 100. You observed that in 2001, inflation and output in England were 5% and
y = 100. In 2002, they were 3% and y = 96. According to the theory of the Phillips
curve, what can you say about expected inflation in 2001 and in 2002?
6. Suppose a country with 400 people is set up so that everybody supplies 10 units of
labour per period no matter how small or large the real wage. In this economy
there are also 1000 competitive firms, each maximising their profit function:
Π = Y P − W N , where Y is output, P is the price of output, W is the nominal
wage and N is the number of units of labour. Suppose each
√ firm is identical in
every respect and each has a production function: Y = N .
(a) Derive the demand for labour of one firm, its output and the aggregate
demand for labour in the economy.
(b) Draw on a graph the aggregate demand and supply of labour. Compute
algebraically the equilibrium wage (W/P )∗ and equilibrium level of labour
supply N ∗ .
(c) Suppose the aggregate demand for goods in the economy is given by
Y = 21 (M/P ) and the money supply is equal to 100. What is the aggregate
supply function for goods in the economy? Calculate Y ∗ and P ∗ .
(d) Suppose that the government increases once and for all the money supply.
Does this improve the position of the workers in the economy?
(e) Would your answer to part (d) change if we also assumed that nominal wages
were rigid in the economy? What would be your answer if prices were rigid?
What does the AS curve look like in the case of rigid wages?

Section A
1. The statement is false. Suggested answers should define what rational expectations
are. In particular, in rational expectations, people not only take all available
134
information into account when they form their expectations, but their expectations
are also consistent with the way in which the variables actually evolve. Rational
expectations are sometimes also known as ‘model consistent’ expectations. If prices
are sticky, agents then know that prices are sticky.
Section B
2. The augmented Phillips curve is shown in (9.3). Replacing actual inflation with
expected inflation, since agents have to make expectations of this unknown
quantity, gives (9.4). Since ζ is a negative function of unemployment, a rise in
expected inflation will increase unemployment for any given wage growth. This
implies that the short-run Phillips curve shifts out. If prices are sticky, then an
increase in expected inflation will cause unemployment to rise above its natural
(full employment) level, at least temporarily. In the long run, prices will adjust,
shown by a higher inflation rate, and unemployment will move back to the full
employment level.
6. (a) Substituting the production function into the profit equation gives us a choice
problem for the firm of √
max Π = N P − W N.
N
Differentiating this with respect to N , setting equal

√ to zero and solving, gives
2 2
a value of N = P /(4W ) per firm and since Y = N , then output per firm is
given by Y = P/2W . With 1000 identical firms, aggregate demand for labour
in the economy, N AD = 250P 2 /W 2 .
(b) If the 400 people in the economy each supply 10 units of labour, irrespective of
the real wage, the labour supply is fixed at 4000. N ∗ therefore equals 4000.
Equating N ∗ with N AD and solving for the real wage gives (W/P )∗ = 1/4.
(c) Since labour supply is fixed at 4000, output produced in the economy will not
be dependent on√demand at all. With 1000 firms, this implies N = 4 per firm
and hence Y = 4 = 2. Aggregate supply is then fixed at Y ∗ = 2000, (i.e. 1000
firms ×2). Equating aggregate demand with supply will allow us to calculate
price, giving P ∗ = 0.025.
(d) An increase in the money supply will shift the aggregate demand curve out
and since the aggregate supply curve is fixed at Y ∗ = 2000, output in the
economy will not change. Equating Y ∗ with aggregate demand, we can see
that the money supply and the price level will move one-for-one. Equating N ∗
(= 4000) with N AD shows us that W and P increase one-for-one so the change
in money supply has no effect on real wages. The position of the workers is
therefore not improved in the economy.
(e) With rigid nominal wages, the increase in the money supply will still shift the
aggregate demand curve out, along the vertical aggregate supply curve.
Output is not affected and again, prices move one-for-one with the money
supply. With an increase in the price level but rigid nominal wages, workers
are worse off since real wages, W/P , are now lower. With rigid prices,
aggregate demand still shifts out but the price level does not change. One may
think that output necessarily increases but since output is not
135
demand-determined in this economy, but is fixed at Y ∗ = 2000, then neither

price nor output change. Nothing happens in the labour market either and the
aggregate supply curve is always vertical.
136
Chapter 10
New Keynesian models of monetary
policy
10.1 Introduction
In the previous chapter, we analysed the effects of monetary policy which utilises
monetary aggregates as the monetary policy instrument. However, modern
macroeconomic research and actual monetary policy implementation suggest that the
current policy instrument is the short-term interest rate controlled by the central bank
via open market operations. Pure classical models suggest that money has no real
effects at any horizon. If we introduce nominal and real frictions or relax some other key
assumptions of the classical model, such as rational expectations, then monetary policy
can have real effects in the short run. In this chapter we will examine the efficacy of a
monetary instrument, the short-term interest rate, using a small scale new Keynesian
macro model.
10.2 Aims
This chapter aims to introduce models with nominal (price) frictions where the
monetary policy instrument are short-term interest rates. We find short-term real effects
of monetary policy under certain conditions.

explain key ingredients of the New Keynesian macro-model
describe the monetary policy reaction function or the Taylor rule
analyse the impact of demand shocks on macroeconomic outcomes
analyse the impact of supply shocks on macroeconomic outcomes
discuss the relevance of financial frictions in such models.
137
10. New Keynesian models of monetary policy
10.4 Reading advice

This chapter follows on directly from Chapter 8 and Chapters 3 and 5 of Carlin and
Soskice (2006) so you should familiarise yourself with the material presented in these
chapters. You should read these while working through this section.
The articles by Carlin and Soskice (2005) and by Taylor (1998) are also essential
reading. Bernanke et al. (1999) discusses the role of financial accelerator in new
Keynesian models.

Books

(Oxford: Oxford University Press, 2006) Chapters 3, 5 and 15.
Journal articles
Aksoy, Y. H.S. Basso, J. Coto-Martinez ‘Lending relationships and monetary policy’,

Economic Inquiry 51 2013, pp.368–393.
Bernanke, B., M. Gertler and S. Gilchrist,‘The financial accelerator in a quantitative
business cycle framework’, Chapter 21, in ‘Handbook of Macroeconomics’, Volume 1,
Edited by J.B. Taylor and M. Woodford, 1999, Elsevier.
Clarida, R., J. Gali and M. Gertler ‘The science of monetary policy: A new Keynesian
perspective’, Journal of Economic Literature 37 1999, pp.1661–1707.
Clarida, R., J. Gali and M. Gertler ‘Monetary policy rules and macroeconomic stability:
evidence and some theory’, Quarterly Journal of Economics 115(1) 2000, pp.147–80.
Kiyotaki, N. and J. Moore ‘Credit cycles’, Journal of Political Economy, 105 1997,
211–248.
Kuttner, K. and T. Robinson ‘Understanding the flattening Phillips curve’, North
American Journal of Economics and Finance, 21 2010, pp.110–125.
Taylor, J.B. ‘Discretion versus policy rules in practice’, Carnegie-Rochester Conference
Series on Public Policy, 39 1993, pp.195–214.
Taylor, J.B. ‘An historical analysis of monetary policy rules’, National Bureau of
Economic Research working paper, w6768, (1998).
10.6 Further reading

Romer, D. Advanced Macroeconomics. (Boston; London: McGraw Hill, 2012, fourth
edition), Chapter 7.
138
10.7. IS-PC-MR model of new Keynesian economics
10.7 IS-PC-MR model of new Keynesian economics

Up to end of 1980’s macro-monetary analysis was dominated by IS/LM models starting
with a graphical analysis. Although standard Keynesian models were under constant
attack from rational expectations economists led by Robert Lucas and Edward
Prescott, among others. They argued that the theoretical foundations of Keynesian
models were weak even absent. It took a long time to bring in some microeconomic
foundations into Keynesian economics. In the last 20 years or so the focus turned into
the Dynamic Stochastic General Equilibrium (DSGE) models with optimising
behaviour of households, firms and sometimes policy makers. This literature uses
methodological foundations of the Real Business Cycle (RBC) research. At the same
time it incorporates:
imperfect competition in the goods market

nominal rigidities, that is, firms cannot adjust their prices continuously in the face
of shocks and/or nominal wage contracts cannot be changed continuously in the
face of the shocks hitting the economy.
This literature, now labelled as the new Keynesian Macroeconomics, is still under
construction. The model implies that the monetary policy conducted by means of
short-term rates can be effective to stabilise inflation and real output in the short run.
It is important to note that the policy is neutral long run. Thus classical dichotomy
between real and nominal variables are still valid under new Keynesian assumptions.
In its simplest form these models have three building blocks:
an IS curve (IS)
a New Keynesian Phillips curve (PC)
an optimal monetary policy reaction function or a simple monetary policy rule
(also known as the Taylor rule) (MR).
In this chapter we will follow closely Carlin and Soskice (2005, 2006) when describing
the key mechanisms of the model. Typically, the model develops a framework of forward
looking households and firms and therefore both IS and Phillips curves are forward
looking, that is, expectations about future real output and inflation matter when
setting optimal consumption and production. For the sake of simplicity, Carlin and
Soskice present a case with a backward looking IS and Phillips curves (that is, looking
at what has happened in the previous period when decisions are made). This is of
course an important simplification and departure from the standard analysis of New
Keynesian models. Other than its usefulness for simplicity, backward looking IS and
Phillips curves can be to some extent justified by the presence of consumers who form
habits in their consumption decisions. That is consumers care about how much they
consumed in the previous periods when they decide about their current consumption.
However, the policy maker, in other words, the central bank, is forward looking when
deciding the level of short-term interest rates by taking the Phillips and IS curves as
constraints. Key assumptions are the presence of nominal rigidities (wages and/or prices
do not adjust instantaneously to shocks hitting the economy) and imperfect
competition.
139
The IS curve is given as:

y1 = A − ar0 (10.1)
where y1 is the actual real output in period 1, A is an autonomous expenditure variable
and r0 is real interest rate set in period 0.
The simplified Phillips curve is given as:
π1 = π0 + α(y1 − ye ) (10.2)
where π1 is the rate of inflation in period 1, where π0 is the rate of inflation in the
previous period. ye describes the ‘trend’ or long-term output and is the level of output
associated with constant rate of inflation. ye reflects the level of real output associated
with the structural features of the economy such as the degree of competition in the
goods market and the nature of the labour markets. The presence of π0 is ad hoc and
based on empirical observations of inflation persistence. Inflation persistence may be a
reflection of backward looking expectations, lags in wage/price setting behaviour,
consumption habits and other types of real/informational imperfections not discussed
here.
The central bank minimises a loss function such that next period inflation (π1 ) is close
to a target inflation level (π T ) and next period real output (y1 ) is close to the ‘trend’
output (ye ) subject to IS and PC equations.
L = β(π1 − π T )2 + (y1 − ye )2 . (10.3)
Note that the parameter β describes the importance of inflation against output gap for
the central bank. The assumption that the central bank can control real rates ensures
that the central bank uses forecasts of the future inflation rate when setting the policy
instrument. We show the precise timing in the 3-equation model in Figure 10.1 (Carlin
and Soskice (2005, 2006)).
To derive the optimal interest rate rule (or the monetary reaction function), Carlin and
Soskice introduce a variable called the short-term interest rate relative to the natural
real rate of interest rs that the central bank chooses when the rate of inflation deviates
from its target or the real output deviates from its trend output. Let us define the real
rate of interest, the interest rate that would prevail when the economy functions at the
full employment level and compatible with trend (or long-term) output as:
ye = A − ars . (10.4)
Subtracting this expression from the IS curve, gives us the IS curve defined in terms of
output gap, i.e. y1 − ye .
y1 − ye = −a(r0 − rs ). (10.5)
The central bank minimises the loss by choosing the (r0 − rs ). After substituting the IS
and PC equations into the central bank loss function, the loss function becomes:
L = β(π0 + α(−a(r0 − rs )) − π T )2 + (−a(r0 − rs ))2 . (10.6)
The central bank chooses (r0 − rs ) optimally. Therefore first order condition with
respect to (r0 − rs ) is given by:
∂L
= 2β(π0 − aα(r0 − rs ) − π T ) · (α(−a)) + 2(−a(r0 − rs )(−a)) = 0. (10.7)
∂(r0 − rs )
140
10.8. Analysing demand shocks
Figure 10.1: Timing: Source (Carlin and Soskice (2005)).
Solving for (r0 − rs ) yields:

1
(r0 − rs ) = 1 (π0 − π T ). (10.8)
a(α + αβ
)
This is the interest rule (IR) as a response to deviations from target inflation and
output gap. For a = α = β = 1 the rule becomes simply:
(r0 − rs ) = 0.5(π0 − π T ). (10.9)
Essentially, by setting the interest rates, the central bank needs to forecast inflation and
output gap next period. Even though the central bank observes the shock in period 0
(we will define in the following sections), due to lagged effect of interest rates on
aggregate demand it cannot fully offset the impact of the shock in the current period.
According to the ‘rule’ interest rates need to increase whenever actual inflation exceeds
target inflation and vice versa. In the following we present a graphical exposition how
the demand-side stabilisation works with respect to demand or supply shocks (Carlin
and Soskice, (2005)).
10.8 Analysing demand shocks

Following Carlin and Soskice (2005, 2006) Figure 10.2 exhibits the vertical (long-run)
Phillips curve at the equilibrium output level, ye , under imperfectly competitive
product and labour markets so that the equilibrium output level is where both wage-
and price-setters make no attempt to change the prevailing real wage or relative prices
and each Phillips curve is indexed by the pre-existing or the past rate of inflation,
141
π I = π1 . The economy is in a constant inflation equilibrium at the output level of ye ;

inflation is constant at the target rate of π T . In the upper panel of Figure 10.2 is the
goods market equilibrium characterised by the IS equation: the stabilising interest rate,
rs , will produce a level of aggregate demand equal to equilibrium (trend) output, ye .
Figure 10.2: IS and Phillips curves: Source (Carlin and Soskice (2005)).
Figure 10.3 shows the case when the economy is subject to an aggregate demand (IS
shock) shock when the target inflation (π T ) is 2 per cent (Carlin and Soskice 2005)). A
positive shock to demand will lead to a positive output gap above the trend output,
which in turn leads to an increase in price inflation above the target level. This is shown
in the lower panel of Figure 10.3. It shows that given the prevailing short-term rate, rs ,
there will be a positive output gap (y > ye ) and associated inflation rate will be π0 > π T
(Point A). The central bank conducts the monetary policy by manipulating the interest
rate r0 . As in Carlin and Soskice (2005), it does so by forecasting the Phillips curve for
next period. Due to the past inflation, its forecast π I will be 4 percent as shown by the
dashed line in the PC diagram. Note that, all points on the forecast Phillips curve with
142
10.9. Analysing supply shocks
inflation below 4 per cent are associated with a negative output gap (y1 < ye ). It is clear
that conducting disinflationary policies is costly in terms of real output output.1
How is the policy maker going to choose the r0 along the new (forecast) Phillips curve?
This depends on the stabilisation preferences of the central bank. If the central bank
cares more about inflation stabilisation relative the output gap, the higher the
preference parameter, β, will be in its loss function. Given that the interest rate
(r0 − rs ) determines output gap which in turn determines the rate of inflation, the more
inflation averse the central bank is, the more it is willing to sacrifice output (below ye )
to achieve its inflation objective. In Figure 10.3 the central bank will choose point B
where the central bank indifference curve (loss function) and the forecast PC will be
tangent. Therefore the new desired output level y1 is the aggregate demand target
according to the optimal monetary policy rule. The monetary reaction function
connects point B and the zero loss point at Z. The next step is to forecast the IS curve
(IS’) associated with desired output level y1 . The dashed line in the upper panel shows
the central bank interest rate r0 in agreement with the new desired output to stabilise
the inflation. Clearly, interest rate needs to increase.
In the absence of further IS shocks, the increase in the interest rate leads to a fall in
output to y1 and inflation starts to decrease. The central bank repeats the steps above
to achieve the target inflation. Essentially, both preferences of the central bank and the
Phillips curve represent the inflation output trade-off the central bank faces. Given the
policy instrument, the short-term rate, the central bank stabilises the economy through
aggregate demand management following an IS (demand) shock.
Temporary or permanent demand shocks
According to our example the central bank needs to decide whether the demand shock is
a temporary or permanent one. If the central bank believes that the shock is permanent
(would persist for another period), central bank policy rate r00 should be higher than the
new stabilising interest rate, rs0 . If the central bank’s forecasts are such that the output
will revert to its initial level, then it will increase the interest rate by less since the
stabilising interest rate would have remained equal to rs (i.e. its chosen interest rate
would have been on the IS pre-shock curve in Figure 10.3 rather than on the IS curve).
10.9 Analysing supply shocks

Structural changes in the economy may lead to a shift in the trend output therefore a
shift in the vertical (long-run) Phillips curve. Prominent examples of such structural
changes are changes in the wage- or price-setting behaviour (curbing labour union
power for instance), a change in tax regime or benefits or changes in the nature of the
goods market competition such that price mark-up changes.
Suppose that the degree of competition intensifies which leads to a shift in the vertical
Phillips curve to the right. Equilibrium output shifts from ye to ye associated with a
1
It is worth mentioning that in other versions of the New Keynesian models demand shocks do not
lead to a trade-off between output and inflation. The central bank can stabilise inflation by stabilising
the output gap. (See, for instance, Clarida et al. (1999).
143
Figure 10.3: New Keynesian model and demand shocks: Source (Carlin and Soskice
(2005)).
stabilising interest rate rs decline at Z’. Short-run Phillips curve corresponding to

inflation equal to the target (shown by the Phillips curve (π I = 2, ye )) shifts to the right
as well. Some observations are in order: first inflation falls from target inflation level of
2 percent to zero percent as the economy moves from equilibrium point A to B. Second,
monetary policy maker should forecast the Phillips curve constraint (Phillips curve
(π I = 0, ye )) for the next period. Corresponding optimal level of output is shown by
point C. To raise output to this level, it is necessary to cut the interest rate in period
zero to r as shown in the IS diagram. The economy is then guided along the MR–AD
curve to the new equilibrium at Z. The positive supply shock is associated initially with
a fall in inflation and a rise in output – in contrast to the initial rise in both output and
inflation in response to the aggregate demand shock. In other words, according to the
model, a supply shock leads to countercyclical inflation, whereas an aggregate demand
shock as in the previous section leads to a procyclical inflation.
144
10.10. Financial accelerator models
Figure 10.4: New Keynesian model and supply shocks: Source (Carlin and Soskice (2005)).
10.10 Financial accelerator models

This section briefly discusses issues that may arise between banks and real economic
activity. Banks are important for economic activity as they often provide much needed
external funding for entrepreneurial activity. It has also been long recognised that
credit-market conditions may themselves be the source factor depressing economic
activity. Bernanke et al. (1999) study a new Keynesian model with a modification for
financial intermediation process that captures credit market imperfections. There are
several ways of doing this within the general equilibrium setting. One is to assume
collateral constraints as in Kiyotaki and Moore (1997), or the existence of lending
relationships as in Aksoy, Basso, Coto-Martinez (2013). Bernanke et al. assume
asymmetric information. They formulate a model where asymmetries of information
play a key role in borrower–lender relationships. In this model, financial contracts
reflect the costs of gathering information about the quality of borrower’s investment
145
project. Several problems can occur in credit markets that may lead to a worsening of
informational asymmetries and increases in the associated agency costs and thereby lead
to fewer projects get external financing. These then will have widespread real effects.2
In their model, there are three types of agents, called households, entrepreneurs, and
retailers. Entrepreneurs play a key role in their model. These individuals are assumed to
be risk-neutral and have finite horizons: Specifically, they assume that each
entrepreneur has a constant probability of surviving to the next period (implying an
expected lifetime of 1/(1 − γ)). In each period t entrepreneurs acquire physical capital
that is financed by either wealth (profits plus labour income) and borrowing that is
subject to external finance premium. If the wealth or net worth is high, this allows for
internal finance therefore entrepreneurs will be able to finance their investment rather
cheaply, or equivalently if they seek external finance they can post these as collateral,
therefore financing the project is less risky. As the external finance needs should be met
via some form of lending contract and there are informational problems about the
quality of the entrepreneurial project (agency problem – uncertain returns on capital
that are subject to both aggregate and idiosyncratic risk), uncollateralised external
finance should be more expensive than collateralised one.
j j j
Bt+1 = Qt Kt+1 − Nt+1 . (10.10)
The expression above formalises the need to borrow from some credit institution. At
time t, the entrepreneur who manages firm j purchases capital for use at t + 1. The
j
quantity of capital purchased is denoted Kt+1 , with the subscript denoting the period in
which the capital is actually used, and the superscript j denoting the firm. The price
paid per unit of capital in period t is Qt . Capital is homogeneous, and so it does not
matter whether the capital the entrepreneur purchases is newly produced within the
period or is old, depreciated capital. At the end of period t (going into period t + 1)
j
entrepreneur j has an available net worth, Nt+1 . To finance the difference between his
j
expenditures on capital goods and his net worth he must borrow an amount Bt+1 . The
entrepreneur borrows from a financial intermediary that obtains its funds from
households. The financial intermediary faces an opportunity cost of funds between t and
t + 1 equal to the economy’s riskless gross rate of return, Rt+1 . The riskless rate is the
relevant opportunity cost because in the equilibrium, the intermediary holds a perfectly
safe portfolio (it perfectly diversifies the idiosyncratic risk involved in lending). Because
entrepreneurs are risk-neutral and households are riskaverse, the loan contract the
intermediary signs has entrepreneurs absorb any aggregate risk. Lenders have to pay a
fee (auditing, accounting, legal and so on) to verify the state of the entrepreneur, so
they incur costs by lending. In equilibrium, Bernanke et al. show that for an
entrepreneur who is not fully self-financed, the return to capital will be equated to the
marginal cost of external finance, i.e.
!
j
k Nt+1
Et Rt+1 = s j Rt+1 . (10.11)
Qt Kt+1
The ratio s(·) of the cost of external finance to the safe rate – which is the discounted
return to capital but may be equally well interpreted as the external finance premium –
2
Remember that Modigliani–Miller theorem implicitly states that the source of funding of a particular
project does not matter for the outcome, be it by firm’s internal resources using, for instance, equity or by
external resources, for instance, using bank loans. When credit markets are characterised by asymmetric
information, the Modigliani–Miller irrelevance theorem is violated.
146
10.11. Simple monetary policy rules
depends inversely on the share of the firm’s capital investment that is financed by the
entrepreneur’s own net worth. It shows that capital expenditures by each firm are
proportional to the net worth of the owner/entrepreneur, with aproportionality
factor
j
Nt+1
that is increasing in the expected discounted return to capital s j
Qt Kt+1
. A high s
reduces default probability and entrepreneurs can take on more debt and expand the
size of the firm, thus economy expands, and vice versa. In other words, financial (or
equivalently credit) constraints can lead to stronger downturns than when these
constraints are absent; hence it works as a financial accelerator.
10.11 Simple monetary policy rules

We conclude this chapter by a brief discussion of the simple policy rules, that is where
monetary authorities implementing policy according to a rule or formula that is chosen
to be applicable over a large number of periods. These are simple rules thus by
definition not reflecting optimal choice of the monetary policy instrument given the
state of the economy as done in the previous sections. Despite reducing the inflation
bias which we will discuss in the chapter, possibly to zero, depending on the rule, such
policy will not be able to counter the productivity shocks that hit the economy. If the
economy is prone to productivity shocks so its variance of was large, it may be desirable
for the monetary authorities to lean against the wind using expansionary monetary
policy in a time of negative productivity shocks, for example. However, to do so will
require discretion on the part of the authorities, but this will naturally lead to the
inflation bias. In the argument of rules versus discretion we have to weigh up the cost of
using discretion (the inflation bias) with the cost of using a rule (inability to counter
productivity shocks).3 Two possible rule scenarios are discussed next.
Taylor rules
Taylor rules are simple monetary policy rules that prescribe how a central bank should
adjust its interest rate policy instrument in a systematic manner in response to
developments in inflation and macroeconomic activity. Following a rule is transparent.
By committing to follow a rule, policy makers can communicate and explain their policy
actions easily and should at least in principle enhance the accountability and credibility
of the central bank.
In Taylor (1998) an interest rate rule of the form:
Rt = πt + g(yt − y ∗ ) + h(πt − π ∗ ) + r∗ (10.12)
was argued to be a valid representation of how nominal interest rates respond to

economic variables for a number of different monetary regimes. Rt is the nominal
interest rate, πt is inflation, π ∗ is the target level of inflation, yt − y ∗ is output
deviations and r∗ is the estimate of the real interest rate. (10.12) can be rewritten, by
collecting terms together to obtain:
Rt = (r∗ − hπ ∗ ) + g(yt − y ∗ ) + (1 + h)πt . (10.13)

3
Note that next chapter discusses inflation bias problem in detail.
147
When fitting this model to US data from 1987, quarter 1, to 1997, quarter 3, the g
coefficient was found to be 0.765 and the coefficient on inflation was found to be 1.533.
The fact that these are positive, and for the case of the coefficient on inflation, greater
than unity, is important for the stability of the economy.
Activity 10.1 Consider (10.12). If inflation was equal to the desired/target rate of
inflation and output deviations were zero (yt − y ∗ ), to what does the equation
collapse?
Consider a fall in demand that causes output to fall below y ∗ with no immediate impact
on inflation. A positive g coefficient implies that nominal interest rates set by the
monetary authorities should fall, since yt − y ∗ is now negative. With no change in
inflation, the fall in nominal rates will decrease real rates and so encourage investment
spending and aggregate demand. Output should then return to the full employment
level. Now consider the case where inflation has increased above the target rate. If the
coefficient on inflation in (11.1) is greater than unity, then the increase in nominal
interest rates will be greater than the increase in inflation. This causes real interest
rates to increase, leading to reduced investment spending and so reduces the
inflationary pressure in the economy. With positive coefficients for g and h (causing
1 + h, the coefficient on inflation in (11.1), to be greater than unity) we should see
stability in the economy, with output tending to be at its full employment level and
inflation staying close to the target rate. If the coefficient on inflation in (11.1) was
found to be less than one (h < 0), then an increase in inflation will be met by a less
than one-for-one rise in nominal rates. This will cause real rates to fall, encouraging
investment and aggregate demand that will cause further inflationary pressure. The
economic system in this case would be unstable.
Friedman’s rule of constant money growth
Due to the long and variable lags associated with the formulation and implementation of
monetary policy, Milton Friedman suggested that trying to control the economy through
changing monetary variables, would purely lead to greater instability. Consider Figure
10.5. At date t0 a shock occurs that causes output to start to fall. The first recorded
data of such an event may become available at date t1 . However, the authorities need
more than just one data observation before changing their policy. After all, the data
reading could be a blip or involve considerable measurement error. At date t2 enough
data are available for the authorities to determine that a downturn is indeed happening
and the decision is made to implement an expansionary monetary policy. Since it takes
some time for the monetary policy decision to take effect, output is only affected at date
t3 , but this is the point when the economy is starting to recover. The monetary
expansion at a time when the economy is naturally starting to accelerate could lead to a
more volatile path for output. Hence, Friedman suggested monetary policy should not
be used to combat output fluctuations, not because of neutrality arguments but because
of the long and variable lags involved with such an activist policy.
148
Figure 10.5:

explain key ingredients of the New Keynesian macro-model
describe the monetary policy reaction function or the Taylor rule
analyse the impact of demand shocks on macroeconomic outcomes
analyse the impact of supply shocks on macroeconomic outcomes
discuss the relevance of financial frictions in such models.
149

Section A
1. ‘Monetary policy is effective in a benchmark New Keynesian model.’
2. ‘Monetary policy is still effective in a New Keynesian model with financial

accelerators.’
Section B
3. Consider a New Keynesian macro model with backward looking inflation in the
Phillips curve. Derive the optimal reaction function of the policy maker that aims
to stabilise inflation. a). Suppose the economy is subject to a temporary demand
shock. How should the policy maker stabilise the economy? Discuss by means of
diagrams. b). Do your results change when the economy is subject to a supply
shock?

Section A
1. The statement is true in the short run. Suggested answers should give examples of
effective monetary policymaking in the presence of nominal and real rigidities. The
model outlined in this chapter shows that the persistence of demand/supply shocks
matters in the determination of central bank forecasts about future Philips curve
and following optimal policy choice.
Section B
2. Students should discuss the effectiveness of monetary policy in a macroeconomic

environment as discussed in the subject guide and in Carlin and Soskice (2005).
150
Chapter 11
Time inconsistency and inflation bias
11.1 Introduction
As discussed in Chapters 5 and 6 there is widespread belief among economists that
inflation is largely a monetary phenomenon. If monetary variations lead to inflation
variations, and if there is a positive statistical relationship between inflation and real
output (or employment) in the short run, governments or politically motivated
monetary policy makers may be tempted to exploit these short run relationships in
order to achieve different objectives. These may range from achieving temporary high
real output, reducing unemployment, financing budget deficits and even attaining
balance of payments objectives by generating surprise inflation. While such outcomes
may be feasible in the short-term, inflationary consequences distort economic agents
incentives in the medium to long run. What is more, economic agents learn the type of
policy makers over time such that they can not be easily fooled. Once consumers, firms
and other agents in the economy understand the incentives of policy makers to create
surprise inflation, they adjust their inflation expectations accordingly such that even in
the short run there can be no output gains to achieve. Thus, we will discuss the so called
inflation bias and ways reduce this bias. A simple game theoretic framework will allow
us to analyse the importance of central banks credibility in the combat of inflation.
11.2 Aims
This chapter aims to discuss strategic interactions between policy makers and economic
agents which may differ in their incentives with ultimate welfare deterioration for the
society. We also study how to resolve these conflicts of interests.

describe the causes of ‘inflation bias’ in an economy
distinguish between ‘wet’ and ‘hard nosed’ central banks
outline institutional and behavioural ways inflation bias can be reduced or avoided
describe the workings of the Taylor rule and give conditions needed for stability.
151
11. Time inconsistency and inflation bias
11.4 Reading advice

There is no single textbook that covers the material in this chapter but the most
appropriate are those by Carlin and Soskice (2006) and Goodhart (1989) and you
should read these while working through this section.
The articles by Carlin and Soskice (2005), Barro and Gordon (1983), Kydland and
Prescott (1977) are also essential reading. The Goodhart article gives a more historical
account of monetary policy, especially in the UK and US and the article by Orphanides
(2007) provides a neat overview of Taylor rules.

Barro, R.J. and D.B. Gordon ‘A positive theory of monetary policy in a natural rate
model’, Journal of Political Economy 91(3) 1983, pp.589–610.
Chapters 14 and 15.
Kydland, F.E. and E.C. Prescott ‘Rules rather than discretion: the inconsistency of
optimal plans’, Journal of Political Economy 85(3)1977, pp.473–492.
Orphanides, A. ‘Taylor rules’, Finance and Economics Discussion Series: Divisions of
Research Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.,
200718, (2007).
(http://www.federalreserve.gov/Pubs/FEDS/2007/200718/200718pap.pdf)
Taylor, J.B. ‘An historical analysis of monetary policy rules’, National Bureau of
Economic Research working paper, w6768,
(1998).(http://papers.nber.org/papers/W6768)

Books

(Oxford: Oxford University Press, 2006) Chapter 6.
Journal articles
Clarida, R., J. Gali and M. Gertler ‘Monetary policy rules and macroeconomic stability:
evidence and some theory’, Quarterly Journal of Economics 115(1) 2000, pp.147–80.
Goodhart, C.A.E. ‘The conduct of monetary policy’, Economic Journal 99(396) 1989,
pp.293–346.
152
11.7. Time inconsistency and inflation bias
Rogoff, K. ‘The optimal degree of commitment to an intermediate monetary target’,

Quarterly Journal of Economics 100(4) 1985, pp.1169–1189.
Sargent, T.J. and N. Wallace ‘Rational expectations, the optimal monetary instrument
and the optimal money supply rule’, Journal of Political Economy 83(1) 1975,
pp.241–54.
Walsh, C.E. ‘Is New Zealand’s Reserve Bank Act of 1989 an optimal Central Bank
contract?’, Journal of Money, Credit and Banking 27(4, Part 1) 1995, pp.1179–191.
11.7 Time inconsistency and inflation bias

Throughout this subject guide we have stressed that money should be neutral in the
long run but, using models such as the expectations-augmented Phillips curve or the
Lucas supply curve, money can have real effects in the short run. Here, we will use such
a framework to show that in equilibrium, a positive rate of inflation may be present
even though a zero rate may be optimal. If there are no institutional or behaviourial
restrictions, the monetary authorities have an incentive to increase inflation (when
inflation is zero) in an attempt to move along the Phillips curve to increase output. An
‘inflation bias’ may then result in the economy. Let us call such policy makers as being
‘wet’ and those policy makers who always aim for target inflation as being ‘hard nosed’.
Consider for example, the aggregate supply curve in (11.1). This is the same as an
expectations-augmented Phillips curve or a Lucas supply curve, only we use inflation,
πt , instead of the price level.
yt = y ∗ + α(πt − Et−1 [πt ]) + εt (11.1)
y ∗ is the market clearing level of output and εt is a productivity shock term where its
mean is set equal to zero. Suppose the monetary authorities can choose the inflation
rate directly and try to minimise the following loss function:
L = πt2 + λ(yt − ky ∗ )2 where k > 1. (11.2)
λ is a preference parameter showing the authorities’ preference for output fluctuations

relative to inflation fluctuations. We assume that k > 1 so that a level of output greater
than the market clearing level is desired reflecting political biases towards higher
output. If output is at the market clearing level, a social loss is still incurred,
(y ∗ − ky ∗ )2 > 0, since the socially optimum level of output may be greater than the
market clearing level. This may be due to the fact y ∗ is too low because of the
monopoly powers of firms, for example, which causes output levels to be sub-optimal
and hence unemployment to be too high. This is shown in Figure 11.1.
Initially, we are at the market clearing level of output and have zero inflation, point A.
If output equals its market clearing level in the long term, this point is the best
(welfare-maximising) that can be achieved. However, the monetary authorities know
that by increasing inflation unexpectedly, we can move along the Phillips curve to point
B, obtaining a higher level of welfare. At point B the inflation rate is higher than
expected since E[π] = 0. Expected inflation therefore increases and the Phillips curve
shifts up. The equilibrium compatible with expected inflation, point E, is the point
where the Phillips curve is tangential to the indifference curve. At this point the
153
Figure 11.1:
authorities have no incentive to increase inflation since to do so will result in lower

social welfare. Note that at point E, we have a positive rate of inflation, the inflation
bias, and we are on a lower level of social welfare than at point A, our starting point.
To calculate the inflation bias, substitute the Phillips curve into the loss function, (11.2).
L = πt2 + λ((1 − k)y ∗ + α(πt − Et−1 [πt ]) + εt )2 . (11.3)
Differentiating this with respect to the choice variable, π, taking expectations of

inflation as given, setting equal to zero and solving for πt will give us:
(1 + α2 λ)πt = α2 λEt−1 [πt ] + αλ((k − 1)y ∗ − εt ). (11.4)
Taking expectations of (11.4) conditional on information at date t − 1, noting that

Et−1 [εt ] = 0, will give a solution for Et−1 [πt ]. Substituting back into (11.1) will give a
solution for inflation.
Et−1 [πt ] = αλ(k − 1) = y ∗
αλεt
πt = αλ(k − 1)y ∗ − . (11.5)
1 + α2 λ
The inflation bias is given by Et−1 [πt ] = αλ(k − 1)y ∗ and represents the vertical distance
AE in Figure 11.1. Note that when parameter k = 0, there is no inflation bias as we
have seen in the previous chapter.
154
11.8. Inflation aversion, steepness of the Phillips curve and interest rates
11.8 Inflation aversion, steepness of the Phillips

curve and interest rates
There are three elements that determine the level of inflation bias.
the political bias towards higher output parameter (k > 1)
the degree of central bank inflation aversion in the loss function (λ)
the responsiveness of inflation to output in the Phillips curve (α).

The parameter λ in the central bank’s loss function (equation (11.2) governs the
inflation aversion of the central bank. If λ is equal to 1, indifference curves in Figure
11.2a. are circles and the central bank assigns equal weight to inflation and real output
in the loss function. In alternative scenarios where λ is not equal to 1, indifference
curves are elliptical. If λ is less than 1, the central bank is inflation averse (hard nosed).
Finally, if λ is more than 1, the central bank is real output (or unemployment) averse
(wet). These scenarios are depicted in Figure 11.2.
Figures 11.2b and 11.2c show differences between central bank responses. Given a
Phillips curve, Figure 11.2b shows that when current inflation deviates from a target
inflation level, the central bank will respond more aggressively to stabilise inflation back
to its target level and Figure 11.2c shows that the central bank’s response will be muted
when inflation deviates from its target level since the central bank is more concerned
with real output.
Figure 11.2:
The parameter α measures the slope of the Phillips curve or alternatively, the
responsiveness of inflation to changes in output. The higher the parameter α, the more
responsive is inflation to changes in output. Given the central bank preferences, a
steeper Phillips curve implies less aggressive policy response when the inflation deviates
from the target level. A steeper Phillips curve allows the central bank to do less in
response to an inflation shock since inflation responds strongly to a fall in output
155
associated with a tight monetary policy. For more discussion on the matter, see Carlin
and Soskice (2005).
We will now outline a number of ways in which this inflation bias can be
reduced/negated.
11.9 Ways inflation bias can be reduced
11.9.1 Delegation of monetary policy to a conservative central

bank: central bank independence
If the role of monetary policy was delegated to such a conservative central bank, which
is less concerned with output variations than the society, in other words, has a loss
function of the form in (11.2) where µ < λ:
LCB = πt2 + µ(yt − ky ∗ )2 (11.6)
then we will still be faced with an inflation bias but the bias will be of the form
αµ(k − 1)y ∗ and since µ < λ, the inflation bias will be lower.
One way to formalise a conservative central bank is to establish an independent central
bank with a formal price stability mandate. The popularity of independent central
banks during the 1990s can be seen as an attempt to separate monetary policymaking
from political interference. Establishing an independent central bank, of course, is not
sufficient to guarantee price stability if price stability is not part of their mandate. In
order to ensure their commitment to price stability, most central banks in advanced
economies recently adopted the so called ‘inflation targeting policy’. This typically takes
the form of a targeting policy with an explicit inflation target around two percent to tie
down inflation expectations. While in some advanced economies, notably in the case of
the US Federal Reserve, there is no formal central bank independence, historical practice
suggests that there is no political pressure. Also, there were regular announcements by
Fed officials about the desired level of inflation. In 2012, the than Chairman of the
Federal Reserve, Ben Bernanke announced an inflation target of 2 percent departing
from the non-committal stance of the Federal Reserve. Interestingly, in the aftermath of
the global financial crisis in September 2008 there has been serious questioning of such
inflation targeting policies in particular at times of high unemployment and weak
output performance. A renewed scrutiny of the role of monetary policy other than price
stability (such as unemployment and real output) in an economy has started and the
debate is as yet unsettled. (See for instance writings of Paul Krugman in popular press.)
One possible alternative to inflation targeting is the so called ‘nominal income
targeting’ as such policy captures both inflation and real output at the same time.
11.9.2 Inflation contract for the central bank

Suppose the central bank was penalised, by way of reduced salary, for allowing any
inflation above the socially desired level, set in this case at zero. The loss function that
would be minimised would then be:
LContract = πt2 + λ(yt − ky ∗ )2 + Ψπt . (11.7)
156
So that the central bank’s loss depends on the level of inflation through the Ψ
parameter as well as squared inflation and squared output deviations. If we substitute
the Phillips curve into (11.7) and minimise the loss function by choosing πt (using the
same method as above), it can be shown that the inflation bias, Et−1 [πt ], is given by:
Ψ
Et−1 [πt ] = αλ(k − 1)y ∗ − . (11.8)
2
Therefore, if the contract was written for the central bank such that Ψ = 2αλ(k − 1)y ∗ ,
then the inflation bias would be zero and one would achieve the point of highest
attainable welfare, point A in Figure 11.1, as a time-consistent equilibrium.
11.9.3 Reputation
Policy credibility is at the core of monetary policymaking. A ‘hard nosed’ central bank
cares only about inflation, whereas a ‘wet’ central bank attempts to exploit short-term
relationships. However, even a ‘wet’ central bank can avoid inflation bias problem by
establishing a reputation that it is serious about inflation. Such reputation can only be
achieved in a multi period game between sceptical wage setters and the policy maker.
Carlin and Soskice (2006) illustrate the point by using a two period game. Let us
suppose that in period 1, the society chooses an expected inflation (π1E ) with the
knowledge that there is a certain probability, p, that the central bank is serious about
inflation. Equipped with this knowledge, the central bank chooses output at, say, y1 . In
period 2 the society chooses (π2E ) knowing how the central bank behaved in period 1
(that is they observe y1 ); the central bank chooses y2 knowing (π2E ), and so on. In this
scenario, even a ‘wet’ central bank will behave in period 1 as if it is ‘hard nosed’ about
inflation. This is because by behaving tough on inflation in period 1, inflation will be on
target and output on equilibrium. In period 2 (terminal period), however, the central
can set output above the equilibrium by creating surprise inflation. When the reasoning
extended to many periods, it pays off for the central bank to build a reputation of being
tough on inflation. The ‘wet’ central bank would behave as if it is a ‘hard nosed’ central
bank in all periods except the very last one of the game. The model provides a
justification for the incentives to build a reputation of inflation toughness when the
society is sceptical about the ‘nature’ of the central bank.

describe the causes of ‘inflation bias’ in an economy
distinguish between ‘wet’ and ‘hard nosed’ central banks
outline institutional and behavioral ways inflation bias can be reduced or avoided
describe the workings of the Taylor rule and give conditions needed for stability.
157

Section A
1. ‘Monetary policy makers only care about inflation.’
Section B
2. Discuss the main arguments in the debate rules versus discretion.
3. What is the Taylor rule and why are the size and sign of its parameters important
for economic stability?
4. Country A’s monetary policy rule has been estimated to be:
Rt = 0.6 + 1.6(πt − π ∗ ) + 0.4(yt − y ∗ )
and country B’s monetary policy rule is described by:
Rt − 0.6 + 0.5(πt − π ∗ ) + 0.4(yt − y ∗ )
where π is inflation, y is output, π ∗ is the inflation target and y ∗ is equilibrium

output. The standard deviation of the output gap in country A is 0.48 and in
country B it is 1.05.
Explain why, although the coefficient on the output gap is the same in the two
countries, the variance of output is lower in country A.
5. Suppose the central bank was penalised, by way of reduced salary, for allowing any
inflation above the socially desired level, set in this case at zero. The loss function
will then be:
LContract = πt2 + λ(yt − ky ∗ )2 + Ψπt .
Prove that under this loss function, the inflation bias will be:
Ψ
Et−1 [πt ] = αλ(k − 1)y ∗ − .
2

Section A
1. False. Students should answer this by providing a brief discussion on inflation bias
(the political bias towards a higher output) and how to resolve the problem.
158
Section B
2. To answer this question we can follow the procedure used earlier in this chapter.
Equate aggregate demand and aggregate supply and collect terms in pt to obtain
(α + β1 )pt = β0 + β1 mt + vt − y ∗ + αEt−1 [pt ].
Take expectations conditional on date t − 1 information, noting that Et−1 [vt ] 6= 0.

Subtract this from the above expression to obtain an expression for pt − Et−1 [pt ].
Substituting this into the Lucas supply curve and noting that mt − Et−1 [mt ] = et
and vt − Et−1 [vt ] = εt , gives us:
α
yt = y ∗ + (β1 et + εt ).
α + β1
The systematic component of monetary policy does not enter this expression and
therefore, even though the monetary authorities react to a series of shocks in the
economy, monetary policy is still ineffective. The expression for the output gap,
yt − y ∗ can be written as:
α
yt = y ∗ + (β1 (mt − µ0 − µ1 vt−1 ) + εt )
α + β1
simply by replacing et . This can also be written as
yt = y ∗ + γ0 + γ1 mt + ηt .
From this equation, we may think that there is a positive relationship between
money and output since the coefficient on mt is positive. This is not true, however.
See the section on the Lucas critique in this chapter.
6. The variance of output in country A is lower than that in country B because the
coefficient on inflation in the Taylor rule is greater than unity, while in country B it
is less than 1. In country A, if inflation increases by 1%, due to an overheating
economy for example, the nominal interest rate increases by 1.6%, so causing real
rates to rise by 0.6%. This reduces the inflationary pressure in the economy by
dampening demand. In country B, a similar rise in inflation leads to a rise in
nominal rates of only 0.5%. This implies real rates fall, so increasing demand in the
economy when it is already overheating. If output increases when it is already too
high, this implies output is not stable, explaining the greater variance of output in
country B.
159
160
Chapter 12
Monetary policy and data/parameter
uncertainties
12.1 Introduction
Throughout the Guide we assumed that:
the central bank is assumed to know the true model of the economy,
the central bank observes accurately all relevant variables timely and accurately,
the central bank knows sources and properties of economic disturbances.

For instance, in Chapter 9, we discussed New Keynesian model of monetary economics.
Depending on the nature of the shock (permanent or transitory, demand or supply) the
central bank can change the interest rates as soon as the shock is observed. There is no
role for caution in this setting.
In practice, conducting monetary policy is very difficult. There is tremendous
uncertainty about the true structure of the economy, the impact policy actions have on
the economy, and even about the state of the economy. Following quote from a
prominent former central banker, Alan Blinder (1995), who was speaking at a meeting
in Minnesota best describes the challenges a central banker faces:
‘Unfortunately actually to use such a strategy in practice you have to use forecasts
knowing that they may be wrong. You have to base your thinking on some kind of
monetary theory even though that theory might be wrong. And you have to attach
numbers to that theory knowing that your numbers might be wrong. We at the Fed
have all these fallible tools and no choice but to use them.’ Blinder continues to suggest
the following ‘What can you do to try to guard against failure? First of all be cautious.
Dont oversteer the ship. If you yank the steering wheel really hard a year later you may
find yourself on the rocks.’
Blinder suggests to exercise caution in monetary policymaking. This effectively
translates into a smooth adjustment of interest rates. The reasons for smooth
adjustment of interest rates can be due to:
data uncertainty (alternatively, additive uncertainty),
parameter uncertainty (alternatively, multiplicative uncertainty).
161
12. Monetary policy and data/parameter uncertainties
12.2 Aims
This chapter aims to introduce two major challenges, data and parameter uncertainty,
that policy makers will face in deciding the monetary policy.

Discuss the importance of additive uncertainty
Distinguish between news and noise in data revisions
Discuss the choice of monetary policy instruments under additive uncertainty
Discuss the importance of parameter uncertainty
Explain the concept of certainty equivalence.
Explain optimal policy conduct when the economy subject to parameter

uncertainty.
12.4 Reading advice

This chapter follows the work by Aruoba (2008) for discussions of data uncertainty and
Brainard (1967) for discussions of parameter uncertainty. For empirical evidence see
Aruoba (2008) and Sack (2000). For optimal policy instrument choice under data
uncertainty you should read Poole (1970).

Aruoba, B. ‘Data revisions are not well-behaved’, Journal of Money, Credit and
Banking, 40(2–3) 2008, pp.319–340.
Brainard, W. ‘Uncertainty and effectiveness of policy’, American Economic Review
(papers and proceedings), 57 (2) 1967, pp.411–425.
Poole, W. ‘Optimal choice of monetary policy instrument in a simple stochastic macro
model’, Quarterly Journal of Economics, 84 (2) 1970, pp.197–216.

Croushore, D. and T. Stark, ‘A real time dataset for macroeconomists: does the data
vintage matter?’ Review of Economics and Statistics, 2003 pp.605–17.
162
12.7. Data uncertainty
Sack, B. ‘Does the Fed act gradually? A VAR analysis’ Journal of Monetary Economics,
46 2000, pp.229–256.
12.7 Data uncertainty

Economic agents (policy makers, financial agents, firms, households) possess information
and form their forecast in real time. As it turns out, most macroeconomic data is
subject to continuous revisions. We can define data revisions in the following way.
Xtf = Xtp + rtf . (12.1)
where Xtp denotes the statistical agency’s initial announcement of a variable that was
realised at time t, Xtf denotes the final or true value of the same variable and rtf
denotes the final revision which may potentially be never observed.
These data revisions, rtf , can be due to:
short run revisions based on additional source data or
benchmark revisions based on structural changes or updating base year.

If those revisions are done because of new data arrivals that are not forecastable at the
time of the forecast (news), we can refer to ‘well behaved’ revisions since there is
nothing economic agents can do about these. If, however, future data revisions are
forecastable at the time of the forecast these are not well behaved revisions (noise). By
not making use of the forecastablity of future revisions, economic agents would violate
one of the main assumption of modern macroeconomics, that is rationality. Well
behaved revisions have three properties.
Revisions should have a mean zero. i.e. initial announcement of the statistical
agency should be an unbiased estimate of the final value of the data.
Final revision should be unpredictable given the information set at the time of the
initial announcement and
The variance of the final revision should be small compared to the variance of the
final value of the data.
Aruoba (2008) shows vast empirical evidence that none of these properties of well
behaved revisions are full-filled in the US data. The measurement problem is more
important for output series than it is for inflation or employment/unemployment series.
We first look at a case where we assume that the structure of the economy is known
with certainty. However, we also assume that the economy may be subject to additive
shocks; this creates data uncertainty.
Data (additive) uncertainty in Poole’s model
Poole (1970) analysed the implication of adding such news shocks to both the IS and
LM schedules. Such shocks could come about from for instance changes in consumer
tastes or government expenditures shocks on the IS side and stock market crashes and
163
financial crises such as the collapse of LTCM in 1998 or a change in the central bank
behaviour on the LM side. Poole’s model assumes that the parameters and structure of
the model are known with certainty, which is an unrealistic assumption, but allows the
IS and LM schedules to be subject to zero-mean random errors, again the so called
news shocks. Define IS and LM schdules as:
Y = a − bR + ε (12.2)
M = c − dR + eY + η.
ε and η are additive IS and LM shocks whose variances are σε2 and ση2 respectively, and
for simplicity we ignore the price level in the LM curve. Alternatively, assume the
monetary authorities can control real money balances, denoted by M . The authorities
can either set the money supply, M , or the interest rate, R, but not both. With a
downward-sloping money demand schedule, either R or M can be set and the other
variable will have to change to allow the markets to clear. If the authorities set the
interest rate, then from the IS schedule, the expected value of output, Y , given R,
denoted E[Y | R] will be:
E[Y | R] = a − bR. (12.3)
Assume that the goal of the policy makers is to minimise the variance of output. From
(12.2) and (12.3), Y − E[Y | R] will simply be ε and so the variance of output given that
the authorities set the interest rate will be E[Y − E[Y | R]]2 = σε2 . Alternatively, the
monetary authorities could set the money supply, M . In order to calculate the variance
of output in this scenario, we need to calculate Y as a function of M only. From the LM
schedule, we can calculate R as a function of M , Y and η and then substitute this into
the IS curve. Solving for Y will give:
ad − bc bM dε − bη
Y = + + . (12.4)
d + be d + be d + be
We can then find E[Y | M ] and the variance of output given that the authorities directly
control the money stock. This is given in 12.5.
2
2 1
E[Y − E[Y | M ]] = (d2 σε2 + b2 ση2 ). (12.5)
d + be
We can now examine which policy instrument, when set by the authorities, will result in
a lower output variance. Consider the case where there are no IS shocks, σε2 . The
variance of output under both interest rate and money targeting regimes is given in the
top line of Table 12.1. It is clear that setting the interest rate and allowing money to
change to clear the market is the optimal strategy. However, if there are no LM shocks,
ση2 , then output variance is smaller under a policy of fixed money supply, see the
bottom line of Table 12.1. Therefore, if an economy is prone to IS shocks, the
authorities should keep the money supply constant. If the economy is prone to money
market, LM, shocks, the interest rate should be the instrument of choice.
This is also shown in Figures 12.1a and 12.1b. Figure 12.1a shows the case with IS
shocks only. The output variation when the interest rate is fixed at R∗ is shown by |R ,
in which case the money supply has to change to clear the money markets causing the
LM curve to shift so that equilibrium is at points A or B. If the money supply was kept
164
12.8. Parameter (or multiplicative) uncertainty
b
2
Only LM shocks, σε2 = 0 Var[Y | R] = 0 < Var[Y | M ] = d+be
ση2
d
2
Only IS shocks, ση2 = 0 Var[Y | R] = σε2 > Var[Y | M ] = d+be
σε2
Table 12.1:
fixed then output deviations are shown by |M . Therefore, with IS shocks, in order to
keep output variance at a minimum, it is best to keep the money supply fixed.
In Figure 12.1b, by keeping the interest rate fixed after LM shocks, equilibrium will be
unchanged at point E and output variance will therefore be zero. By keeping the money
supply fixed, however, LM shocks will cause equilibrium to move between points A and
B and output variance will be positive, equal to ∆Y |M . So, depending on the main
source of economic shocks, whether they originate from the goods or money markets,
will determine which monetary instrument the authorities should target.
Figure 12.1: Poole’s analysis.
12.8 Parameter (or multiplicative) uncertainty

Whereas Poole considered the case where shocks were additive in nature, Brainard
(1967) examined the case where the values of the parameters in the model were not
known with certainty. This is, arguably, more realistic since any model must be
estimated from data. An estimated model will not only give point estimates of the
parameters but will also give standard errors since there will always be measurement
error, model mis-specification and other problems that cause us not to know the exact
structure of the economic model. Suppose output, y, depends on a policy mix, X, a
165
vector containing fiscal and monetary instruments that the government can control. The
relationship between y and X is given by:
y = gX. (12.6)
For simplicity, assume X is a single policy instrument so that g is a scalar parameter

estimate with mean gb and variance σg2 . The aim of the authorities is to minimise the
variance of y around some target level, y ∗ , full employment level of output for example,
subject to the constraint (8.13), i.e.
min E[y − y ∗ ]2 s.t. y = gX. (12.7)
If y = gX, taking averages will give yb = gbX. The problem can then be written as:
min E[(y − yb)X − (y ∗ − yb)]2 s.t. y = gX
⇒ min E[(g − gb)X − (y ∗ − gbX)]2
⇒ min E[(g − gb)2 X 2 + (y ∗ − gbX)2 − 2(g − gb)X(y ∗ − gbX)]. (12.8)
Noting that E[g − gb]2 = σg2 and that E[g − gb] = gb − gb = 0, the problem then becomes:
min X 2 σg2 + (y ∗ − gbX)2 . (12.9)

X
Differentiating this with respect to X, the choice variable, setting equal to zero and
solving will give:
gby ∗ gb2 y ∗
X= 2 ⇒ yb = gbX = 2 < y∗. (12.10)
σg + gb2 σg + gb 2
The implication of the model is that because of the presence of uncertainty, σg2 > 0, the
authorities will never push aggressively enough to make average output equal to the
target level, y ∗ . To do so will simply cause output variation to increase to an intolerable
level. The policy maker would rather have a stable level of output below the full
employment level than very volatile output whose average was y ∗ . This is shown in
Figure 12.2.
From y = gX and yb = gbX, it follows that σy2 = σg2 X 2 which implies X = σy /σg .
Substituting into y = gX will give the linear policy constraint in Figure 12.2. The
authorities try to reach the indifference curve closest to y ∗ , the target level, subject to
the policy constraint and as can be seen in Figure 12.2, the presence of uncertainty, σg2 ,
causes the authorities to opt for a less aggressive policy stance, causing equilibrium
output to be below y ∗ .
Activity 12.1 What happens in Figure 12.2 when the uncertainty, shown by σg2 ,
increases? Do the policy makers become more or less aggressive in reaching the
target level of output, y ∗ ? Explain.
166
12.8.1 The New Keynesian model and parameter uncertainty

In this section we will apply Brainard’s ideas to a simple macroeconomic model in the
New Keynesian spirit. We will show that if there is no parameter uncertainty, and the
economy is subject to additive shocks with mean zero and constant variance, the policy
maker should behave in a certainty equivalent manner, that is if the economic shocks
did not occur. If, however, the economy is subject to structural changes as exemplified
in parameter uncertainty, than Brainard conservatism applies. Now, suppose that the
economy is characterised by:
πt = yt + aπt−1 (12.11)
and
yt = −bit + εt (12.12)
with
ε ∼ (0, σε2 ) (12.13)
where π stands for inflation, y for the business cycle component of real output (or
income), i for the short term rate that the policy maker can control and ε for the
stochastic demand shocks hitting the economy. We assume that the mean value of these
shocks are equal to zero and their variance is given by σε2 and these are known by the
policy maker. Parameters a and b are constants. By substituting (12.12) into (12.11) we
obtain an expression for current inflation as a function of past inflation, the policy rate
and shocks hitting the economy.
πt = aπt−1 − bit + εt . (12.14)
167
The policy maker cares about inflation stabilisation. Suppose that the quadratic loss
function of the central bank takes the following form:
L = (πt − π ∗ )2 (12.15)
where π ∗ represents the target inflation. In other words, whenever the current inflation
deviates form the target inflation, the policy maker has an incentive to bring back the
inflation to its target level by manipulating the policy rate, i.
The case with additive uncertainty
The only source of uncertainty is the presence of stochastic shocks. Given that the
policy maker knows the nature of the shocks with a mean of zero (E(ε) = 0) and a
constant variance (E(ε2 ) = σε2 ), it will form an expectation about these. Substitute the
perceived structure of the economy into the objective function of the central bank:
Le = E(aπt−1 − bit + εt − π ∗ )2
or
Le = a2 πt−1
2
+ b2 i2t + E(ε2 ) +π ∗ 2 − 2aπt−1 bit + 2aπt−1 E(εt )
| {z } | {z }
σε2 0
∗ ∗ ∗
−2aπt−1 π − 2bit E(εt ) +2bit π − 2 E(εt ) π .
| {z } | {z }
0 0
Note that, by setting E(ε) = 0 and E(ε2 ) = σε2 we have inserted policy makers
expectations about the shocks. The policy maker’s job is to minimise the loss with the
use of the monetary policy instrument it .
∂Le
= 2b2 it + 2bπ ∗ − 2aπt−1 b = 0
∂it
−π ∗ + aπt−1
it = .
b
It is important to notice that policy rate set by the policy maker is the same as the one
that it would set if there were no shocks hitting the economy. This is the certainty
equivalence result. That means additive shocks do not affect the way monetary policy is
conducted. The best the policy maker can do is simply to ignore them.
The case with parameter uncertainty
Now, we can include a bit of complication. The economic environment is the same as in
the previous section except that the parameter b of the real income equation is allowed
to vary over time. We capture this by adding a time subscript to parameter b.
Specifically:
yt = −bt it + εt (12.16)
with
ε ∼ (0, σε2 ), b ∼ (bb, σb2 ) (12.17)
168
where the shocks are still additive, however we also see that the parameter b has a
certain distribution such that its mean is bb and its variance is σb2 . It is important to note
that this information is available to the policy maker such that it can form expectations
about the value of the parameter b.
By substituting (12.16) into (12.11) we obtain again an expression for current inflation
as a function of past inflation, the policy rate, the shocks hitting the economy and the
novel element of time varying parameter b.
πt = aπt−1 − bt it + εt . (12.18)
The problem of the central bank now becomes:
Le = E(aπt−1 − bt it + εt − π ∗ )2
= a2 πt−1
2
+ E(b2t )i2t + E(ε2 ) +π ∗ 2 − 2aπt−1 E(bt )it + 2aπt−1 E(εt )
| {z } | {z }
σε2 0
∗ ∗ ∗
+2aπt−1 π + 2E(bt )it E(εt ) −2E(bt )it π − 2 E(εt ) π .
| {z } | {z }
0 0
Remember that you can write the variance of b as σb2 = E(bt − bb)2 = E(b2t − 2btbb + bb2 ).
Given that E(bt ) = bb that is equal to σb2 = E(b2t ) − E(bb2 ). That allows us to rewrite the
Le as:
Le = a2 πt−1
2
+ E(b2t )i2t + σε2 + π ∗ 2 − 2aπt−1 E(bt )it + 2aπt−1 π ∗ + 2E(bt )it π ∗
 
= a2 πt−1
2
+ sigma2b + E(bb2 ) i2t + σε2 + π ∗ 2 − 2aπt−1 E(bt ) it + 2aπt−1 π ∗ + 2 E(bt ) it π ∗
 
| {z } | {z } | {z }
b2
b b
b b
b
= a2 πt−1
2
+ σb2 i2t + σε2 − 2aπt−1bbit + 2aπt−1 π ∗ + bb2 i2t + π ∗ 2 + 2bbit π ∗ .
We can now solve the policy maker’s optimisation problem that is:
∂Le 2

∗ b
= 2σb it − 2aπt−1 b + 2 bit + π b = 0
b b
∂it
(aπt−1 − π ∗ )bb
it =
(σ 2 + bb2 )
b
(aπt−1 − π ∗ )
= .
(σ 2 + bb2 )/bb
b
The expression σb /bb refers to the coefficient of variation. It represents the trade-off
between returning inflation to target and increasing uncertainty about inflation depends
on the variance of the parameter relative to its mean level. A large coefficient of
variation means for a small reduction in the inflation bias the central bank induces a
large variance into future inflation. Once parameter uncertainty is taken into account
inflation variance depends on the interest rate reactions. Policy maker’s decisions affect
uncertainty of future inflation. Hence, rather than strong reaction or ‘cold turkey’,
gradualism (sustained policy reaction) is preferable (Brainard conservatism).
169
12.8.2 Graphical exposition
Finally, we can show the effect of data and parameter uncertainties on policymaking in
a simple graphical setting. Consider Figure 12.3 following Sack (2000).
Suppose that there is a negative relationship between real output (horizontal axis) and
policy rates (vertical axis, which characterises the IS curve. Upper panel shows the case
without any uncertainty. As is clear whenever the actual output deviates from desired
output, the policy maker can adjust policy rates to reach the desired level. Middle panel
shows the case with additive uncertainty (only news shocks are considered here). Here,
the policy maker is not sure about the quality of the data it receives (as shown by
parallel dashed lines). Nevertheless, it acts as if it knows the data with certainty, as
there is nothing it can do about the shocks (certainty equivalence). Finally, lower panel
shows the case with parameter uncertainty. Since, the nature of the relationship
between output and policy rate is time-varying, the slope is changing over time. If the
policy makers acts with aggression, that is trying to reach the desired output by
increasing the policy rate a lot, the economy may find itself at an equilibrium that is
even less desirable than before. What can the policy maker do?
170
12.9. Interest rate smoothing
In Figure 12.4 Sack (2000) demonstrates a possible alternative to the bad outcome in
line with the analytical discussion in the previous section. The policy maker moves in
steps (interest smoothing). First, it adjusts the policy rates in the right direction. When
the (relatively benign) state of the economy is revealed, it moves again in the same
direction. The policy maker thereby exploits arrival of new information and can reduce
the size of potential errors it can commit.
12.9 Interest rate smoothing

As mentioned in the introduction central banks tend to change interest rates i) in small
steps and ii) often in the same direction for consecutive periods. Figure 12.5 shows this
case for the three major central banks. The Federal Reserve, the European Central
Bank and the Bank of England. Policy makers are usually not only uncertain about the
state of the economy (data uncertainty) but also on the structural parameters of the
economy therefore interest rates are set in a smooth fashion.
171

discuss the importance of additive uncertainty.
distinguish between news and noise in data revisions.
choice of monetary policy instruments under additive uncertainty.
discuss the importance of parameter uncertainty.
explain the concept of certainty equivalence.
explain optimal policy conduct when the economy subject to parameter

uncertainty.

Section A
1. ‘When the economy is subject to multiplicative uncertainty the best a policy maker
do is to ignore the uncertainty’.
Section B
2. What is the certainty equivalence? Under which conditions can a policy maker act
as if shocks do not happen?
3. Consider a policy maker aiming to minimise quadratic loss associated with actual
inflation over a target inflation. Suppose also that the economic environment
includes forward looking expectations in the Phillips curve such that:
πt = aEt (πt+1 ) − bt it + εt (12.19)
and the parameter b is allowed to vary over time. Note that distribution of the
disturbance term and of the parameter b have following statistical properties:
ε ∼ (0, σε2 ), b ∼ (bb, σb2 ). (12.20)
Calculate optimal interest rate reaction function of the policy maker. Provide an
intuition to your answer.
4. Suppose the economy is subject to i.i.d. mean zero IS and LM shocks. Discuss in a
simple model their implications on the policy instrument choice.
172

Section B
4. The question is about selecting the policy instrument that minimises the variance
of output. Students should show analytically and graphically the impact of IS or
LM shocks. See Poole (1970).
173
174
Chapter 13
The term structure of interest rates
13.1 Introduction
With the exceptions of Chapters 11 and 12, throughout this guide we have only ever
considered ‘the’ interest rate, that is the one set by the monetary authorities, or that is
allowed to change to clear the money markets if the money supply is the instrument of
choice. Even in Chapters 11 and 12, there was only ever one market interest rate. In
reality, there are a large number of interest rates, from those on debt that mature
overnight to interest rates on debt that mature up to 30 years in the future. This
chapter will examine in more detail the links between short-term and long-term interest
rates, explaining why such links are important and providing theories that explain the
short-termlong-term interest rate relationship.
13.2 Aims
This chapter will introduce the relevance of a rich variety of interest rates in financial
and macroeconomic decisions. We will also discuss different term structure theories.

explain what a yield curve is and why it is important for policy makers
list and discuss the different empirical regularities of the yield curve
list and describe the three different theories of the term structure outlined in this
chapter, noting any differences and similarities and stating which theories can
explain which empirical facts
describe the relationship between rates of return and bond prices and why this is so
important for the absence of arbitrage conditions on which the expectations
hypothesis focuses.
175
13. The term structure of interest rates
13.4 Reading advice

The main readings for this section are the chapters in the textbooks by Goodhart
(1989), Harris (1985) and especially Mishkin (2003). Chapter 7 of Mishkin should be
read before starting this part of the subject as it starts by giving a general introduction
to the ideas behind the term structure and then develops the relevant theory. The two
entries in the New Palgrave Dictionary by Malkiel and Mishkin are very useful but the
chapter by Shiller in the Handbook of Monetary Economics is difficult and should only
be read if you feel comfortable with the material.

Chapter 11.
Malkiel, B.G. ‘The term structure of interest rates’, in Newman, P., M. Milgate and J.
Macmillan, 1994).
Mishkin, F.S. The Economics of Money, Banking and Financial Markets. (Boston,
Mass.; London: Addison Wesley, 2003) Chapter 7.
Mishkin, F.S. ‘The yield curve’, in Newman, P., M. Milgate and J. Eatwell (eds) The
New Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994).

Books
Shiller, R.J. ‘The term structure of interest rates’, in Friedman, B. and F. Hahn (eds)
Handbook of Monetary Economics. (Amsterdam: North-Holland, 1990).
Walsh, C.E. Monetary Theory and Policy. (Cambridge, Mass.: MIT Press, 2003)
Chapter 10.
Journal articles
Aksoy, Y. and H. Basso, ‘Liquidity, term spreads and monetary policy’, Economic
Journal, 124, 2014, 1234–1278.
Mankiw, N.G. and L.H. Summers ‘Do long-term interest rates overreact to short-term
interest rates?’, Brookings Papers on Economic Activity (1984) 1, pp.223–247.
McCallum, B.T. ‘Monetary policy and the term structure of interest rates’, National
Bureau of Economic Research working paper, w4938, (1994).
Shiller, R.J. ‘The volatility of long-term interest rates and expectations models of the
term structure’, Journal of Political Economy 87(5, Part 2) 1979, 1190–1219.
176
13.7. The yield curve
13.7 The yield curve

Governments issue a number of differently dated bonds, from short-term paper through
to very long-dated bonds that mature in a number of years in the future. Each bond
will pay a different rate of return, also known as yield to maturity. If we plot on a graph
the time to maturity of government debt on the horizontal axis and the yield to
maturity on the vertical axis, this will give us what is known as the yield curve. An
example of such a curve is shown in Figure 13.1.
Figure 13.1 shows that, for this example, government debt that matures in one month’s
time pays an (annualised) interest rate of 4%. One-year paper pays 6% and debt that
matures in 10 years from now pays an annual rate of return of 9%.
Activity 13.1 What does the yield curve look like in your country?
Figure 13.1:
13.8 Why is the yield curve of importance to

policy-makers?
Central Banks, when setting interest rates, only set one interest rate, normally at the
very short end of the spectrum. In the US, the Federal Reserve sets overnight rates.
However, investment decisions and aggregate demand in the economy will tend to
depend on long-term interest rates since firms will compare the rate of return on
investment projects that accrue over the entire life of the project (15 years plus), to the
177
alternative of buying equivalent dated bonds maturing in 15 years’ time or so. If

aggregate demand depends on long-term interest rates and the monetary authorities set
short-term rates but wish to affect aggregate demand, they will need to know the
relationship between short-term and long-term rates of return (i.e. they need to know
the shape of the yield curve).
But why then do Central Banks not just set long-term rates of return and allow the
market to determine the rates of return along the rest of the yield curve? If the
authorities set long-term rates, they may be faced with large capital losses due to
fluctuations of bond prices in the market. To avoid the possibility of facing large price
variations, the authorities instead set the rate of return on short-dated paper, on which
the possibility of capital gains/ losses is very small or non-existent. However, not only is
the yield curve important for analysing the effects of monetary policy on the economy,
it is also important because it gives information on expected future inflation, as will be
explained below.
13.9 Bond prices and the rate of return

There are, in general, two types of bonds a government can issue. These are:
Coupon bonds. Typically, coupon bonds promise to pay a fixed sum of money, the
coupon, every period, whether it is every month, quarter or year, and also promise
to pay the holder of the bond its face value on maturity. For example, a ten-year
bond may be bought from the government for £100 that promises to pay £5 (the
coupon payment) every year for the next ten years. In the final year, both the last
£5 coupon and the maturity value of the bond, £100, are paid.
Discount bonds. Discount bonds do not offer any interest or coupon payments.
Instead, they are sold at a ‘discount’ and pay a larger amount on maturity. For
example, a ten-year discount bond may be sold today for £60 that pays no coupons
at all but pays £100 on maturity, ten years from now.
Consider a coupon bond that pays C every year from now to infinity. Such bonds,
without a maturity date, are called perpetuities or Consols (the UK term). The price of
this bond, P , will be the future cash flow, discounted back to today by the interest rate,
R, assumed constant here for convenience.

C C C C 1 C
P = + 2
+ 3
+ ··· = = . (13.1)
1 + R (1 + R) (1 + R) 1 + R 1 − 1/(1 + R) R
There is then a negative relationship between the price of a bond and the interest rate.
This was discussed in Chapter 2 when examining Keynes individual money demand
function. (For bonds that do have a maturity date, the relationship between bond prices
and the interest rate, although still negative, is not as simple as (13.1). Intuitively, if the
interest rate increased, people would be willing to pay less for a bond that pays a fixed
coupon payment each period. If a perpetuity bond that paid a coupon of £5 had a price
of £100, this implies the market interest rate is 5%. If the market interest rate doubled
to 10%, no investor would be willing to pay more than £50 for the same bond since the
£5 coupon on a £50 bond is 10%. Hence the bond price and interest rate are negatively
related.
178
13.10. Empirical regularities of the term structure
13.10 Empirical regularities of the term structure

There are three features of the term structure that any theory of the yield curve should
be able to explain:
1. Rates of return on short- and long-dated bonds move together over time.
2. When short rates are low, the yield curve is likely to be upward sloping and vice
versa.
3. Yield curves generally have a persistent upward slope.

We now examine a number of theories that try to explain these features.
13.11 The expectations hypothesis

The expectations hypothesis of the yield curve links the rate of return on short-term
bonds to that on long-term bonds, essentially by assuming that short and long-dated
bonds are perfect substitutes. Consider someone who wishes to save a fixed amount of
money for n periods. She could either buy long-dated bonds now, at date t, that pay
t Rt+n per cent per year. The left-hand subscript denotes the time when the bond is
bought and the right-hand subscript denotes when the bond will mature. Alternatively,
she could buy a bond that matures at date t + 1 (a one-period bond) paying a rate of
return t rt+1 . When this matures she will buy another one-period bond (at date t + 1
that matures at date t + 2) paying a rate of return t+1 rt+2 and will continue doing this
until date t + n. If the return from a portfolio made up of long-dated bonds is not
identically equal to the expected return from continually rolling over one-period debt,
then arbitrage opportunities will be exploited to bring the two returns together.
Suppose for example that a two-year bond paid a rate of return of 4% per year. If the
rate of return on a one-year bond was 3% today and expected to remain at 3% next
year, investors will rush in to buy the longer-dated bond as it pays a higher rate of
return. The increased demand for the two period bonds will push the price up and, as
explained above, will push the rate of return down from 4%. Also, the reduction in
demand for one-period bonds will push the price down, causing the one-period rate of
return to increase from 3%. In equilibrium, under the expectations hypothesis, the total
return from each portfolio must be equal to avoid arbitrage opportunities. Using the
same notation as above, but noting that at date t when the saving decision is made, all
future one-period rates are not known and have to be estimated, then the discount
bond reads:
(1 + t Rt+n )n = (1 + t rt+1 )(1 + t+1 rt+2

e e
)(1 + t+2 rt+3 e
) · · · (1 + t+n−1 rt+n ). (13.2)
The left-hand side is the total return from holding n period bonds until they mature.
The right-hand side is the total expected return from holding and continually rolling
over oneperiod bonds, n times. The rates of return on all bonds bought at date t + 1
onwards are not known at date t, hence the e (expectation) superscript. Taking logs of
179
(13.2), noting that ln(1 + X) ≈ X for small X, gives:

e e e
n · t Rt+n = t rt+1 + t+1 rt+2 + t+2 rt+3 + · · · + t+n−1 rt+n
t+n−1
1 X e
⇒ t Rt+n = sr . (13.3)
n s=t s+1
This is one of the main results of the expectations hypothesis; the long-term interest
rate is an average of the current and all future expected short-term interest rates. The
expectations hypothesis does have a number of criticisms, however:
It cannot explain the empirical fact that the yield curve has a persistent upward
slope. If the long rate is an average of current and expected future short rates, this
can only be explained if the short rate increases through time. This clearly is not
the case.
If the long rate is an average of current and future short rates, the long rate must
be a smoother series (when plotted through time) than the short rate. This is not
true; the long rate is just as volatile.
In order to avoid arbitrage opportunities and keep total returns equal, if the rate of
return on long-term bonds is greater than the return on short bonds, then holding
long-dated bonds must be accompanied by a capital loss (i.e. the price of long-term
bonds must fall). If the price of long-term bonds falls, the rate of return must
increase still further in the next period. Putting this another way: if the long rate is
higher than the short rate, the long rate must increase. This does not happen in
reality.
The expectations hypothesis and expected inflation
If the long rate is an average of the current and expected future short rates, then an
upward-sloping yield curve suggests that the short rate is expected to increase in the
future (see (13.3)). If the real interest rate is constant then the increase in expected
future nominal interest rates must be associated with an increase in expected future
inflation, as per the Fisher equation. The greater the slope of the yield curve, the more
short-term rates are expected to rise and so the faster is inflation expected to increase.
13.12 The segmentation hypothesis

Whereas the expectations hypothesis assumes short- and long-term bonds are perfect
substitutes so the decision as to whether to hold long- or short-dated debt depends
entirely on expected returns, the segmentation hypothesis assumes short- and long-term
bonds are not substitutes in any way. The rate of return on m period bonds will not
depend on the market for, or the return on, m − j period bonds at all. Instead, its rate
of return will depend entirely on the demand for and supply of credit that matures in m
periods’ time. If the demand for m period bonds increased, caused by more people
wanting to save for m periods, then the price of m period bonds will increase and the
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13.13. Preferred habitat theory
rate of return will fall. The markets for m, m + 1, m + 2, etc. period debt are said to be
segmented.
Whereas the expectations hypothesis could not explain the persistent upward sloping
nature of the yield curve, this feature can be easily explained if we use the segmentation
hypothesis. If people generally prefer to hold short-dated debt (i.e. save by buying
shortterm bonds), then this will cause the price of short-term bonds to be high, relative
to longterm bonds, and so the rate of return on short-term debt will then be lower than
the longterm rate, implying an upward-sloping yield curve.
Activity 13.2 Why do you think people would prefer to hold short-term, rather
than long-term, debt?
(Hint: think of the desire to lock up money in long-term bonds and the risk of
capital gains or losses when such holdings have to be liquidated.)
Despite being able to explain persistent upward-sloping yield curves, the segmentation
hypothesis cannot explain the fact that interest rates move together since the markets
are completely segmented. Also, the theory cannot explain why yield curves are upward
(downward)-sloping when short rates are low (high).
13.13 Preferred habitat theory

The preferred habitat theory lies in between the expectations and segmentations
hypotheses. It assumes bonds are neither fully substitutable nor non-substitutable.
Instead, people have a preferred bond maturity they wish to hold (as in the
segmentation hypothesis) but will be willing to move to another bond maturity if the
gains from doing so are significant (so exploiting excess arbitrage opportunities as in the
expectations hypothesis). The preferred habitat theory can be represented as (13.4):
t+n−1
1 X e
t Rt+n = sr + t kn . (13.4)
n s=t s+1
This is exactly the same as the expectations hypothesis, (13.3), except for the inclusion
of a term premium, t kn . If n period bonds were not the bond of choice, then people
would need an extra rate of return in order to encourage them to hold such debt. In this
case t kn would be positive. If people generally tend to prefer short-dated debt then the
term premium will be a monotonic function of maturity; in order to hold longer and
longer dated debt, an increasing term premium must be offered. When combined with
the ‘expectations hypothesis’ component, (13.4) can explain the persistent upward slope
of the yield curve, along with the other empirical regularities: the co-movement of short
and long rates, and the fact the yield curve tends to be upward (downward)-sloping
when short rates are low (high). However, using the term premium to fix the problems
of the expectations and segmentations hypotheses, is arguably a not a proper solution.
A theory of the term premium should be provided, rather than simply assumed in order
to make the data consistent with the ‘fixed’ theory. For a recent paper on a theory of
term premium that builds upon maturity transformation risk faced by the banks, see
Aksoy and Basso (2014).
181

explain what a yield curve is and why it is important for policy makers
list and discuss the different empirical regularities of the yield curve
list and describe the three different theories of the term structure outlined in this
chapter, noting any differences and similarities and stating which theories can
explain which empirical facts
describe the relationship between rates of return and bond prices and why this is so
important for the absence of arbitrage conditions on which the expectations
hypothesis focuses.

Section A
1. ‘Under the segmentation hypothesis, the slope of the yield curve tells us nothing
about expected inflation.’
Section B
2. Empirical fact: yield curves tend to have an especially steep upward slope when
short rates are low and a downward slope when short-term interest rates are high.
Can you explain this fact with the theories of the term structure analysed in this
chapter?
3. Assuming that the expectations hypothesis is the correct theory of the term
structure, calculate the interest rates for one to five year bonds and plot the
resulting yield curves when one year interest rates over the next five years look as
follows:
(a) 5%, 7%, 7%, 7%, 7%.
(b) 5%, 4%, 4%, 4%, 4%.
How would your yield curves change if people preferred shorter-term bonds over
longer-term bonds?
4. If the yield curve was steeply upward sloping, what is the market predicting about
the movements of future short-term interest rates? What might the market predict
about the inflation rate in the future?
5. How can the preferred habitat theory explain the appearance of downward-sloping
yield curves if t kn , the term premium, is positive?
182

Section B
3. From the expectations hypothesis, and in particular (13.3), we can calculate the 2,
3, 4 and 5-year interest rates from the one year rates given in the question.
(a) Using (13.3), we see that:
2 year rate; t Rt+2 = 1 = 2(5 + 7) = 6% per year.
3 year rate; t Rt+3 = 1 = 3(5 + 7 + 7) = 6.33% per year.
The 4- and 5-year rates can be calculated in a similar way to obtain
t Rt+4 = 6.5% per year and t Rt+5 = 6.6% per year. The yield curve is therefore
upward sloping (notice that an upward-sloping yield curve suggests interest
rates will rise in the future; 5% to 7%).
(b) Again using (13.3), we can calculate the 2, 3, 4 and 5-year interest rates to
obtain t Rt+2 = 4.5% per year, t Rt+3 = 4.33% per year, t Rt+4 = 4.25% per year
and t Rt+5 = 4.2% per year. The yield curve is therefore downward sloping (a
downward-sloping yield curve suggests interest rates will fall; 5% to 4%).
If people preferred shorter-term bonds then they would have to receive an
increased rate of return on longer-term debt (over and above that implied by
the expectations hypothesis) in order to encourage them to hold such assets.
In case (a), the yield curve would be even steeper and in part (b), the yield
curve will also be rotated anticlockwise, so becoming more flat, or perhaps
becoming positively sloped if the term premium was large enough.
183
184
Appendix A
Sample examination paper
Important note
This commentary reflects the examination and assessment arrangements for this course
in the academic year 2014–15. The format and structure of the examination may change
in future years, and any such changes will be publicised on the virtual learning
environment (VLE).
Time allowed : three hours
Candidates should answer ELEVEN of the following THIRTEEN questions: EIGHT

from Section A (5 marks each) and THREE from Section B (20 marks each).
Candidates are strongly advised to divide their time accordingly.
If more questions are answered than requested, only the first answers attempted will be
counted.
Section A
Answer ALL EIGHT questions from this section. (5 marks each)

Indicate whether the following statements are true or false, or uncertain and give a
short explanation. Points are only given for a well reasoned answer.
1. The advantage of using fiat money vs. a barter economy is that fiat money no
longer requires trust between transaction partners.
2. The demand of money is positively related to the price uncertainty of assets.
3. Under the preferred habitat theory the slope of the yield curve tells us nothing
about the expected inflation.
4. In Tobin’s portfolio selection model individuals hold either money or bonds.
5. Parameter uncertainty in the Brainard model implies more aggressive fiscal policy
action.
6. The quantity theory of money states that the total value of all monetary
transactions must be equal to the real value of goods and services it buys.
7. According to the standard real business cycle (RBC) theory, money is not neutral.
8. Recessions are best dealt with by conservative central bankers.
185
A. Sample examination paper
Section B
Answer THREE out of FIVE questions from this section. (20 marks each)
9. Consider a classical-Patinkin economy where a representative household utility is a

function of consumption (C) and real money balances (M/P ) such that:
U = C α (M/P )1−α
and the household is subject to a budget constraint given by:
C + M/P ≤ Y + M0 /P
where Y stands initial endowment of goods, M0 stands for initial money balances.
(a) Calculate optimal goods and money demand. Provide intuition. Would your
results change qualitatively if elements (that are real money balances and
consumption) in the utility function were additive, instead of multiplicative?
(b) Is there a role for monetary policy in this setting? What happens when the
economy faces a money supply increase? Show graphically and provide
intuition.
(c) Is the classical theory convincing? Are you aware of alternative macro theories
where monetary policy can be an effective output stabilisation tool? Discuss
analytically one such model.
10. Consider a McCallum economy with sticky prices where the aggregate demand
expression given as:
yt = β0 + β1 (mt − pt ) + β2 Et−1 [pt+1 − pt ] + vt
where yt , mt and pt are the logs of real output, nominal money balances and the
price level respectively at date t, vt is an i.i.d. normal aggregate demand shock with
vt ∼ (0, σv2 ) are positive parameters and E is the expectations operator. To
construct the aggregate supply assume the following:
(i) the market clearing price is denoted by p∗t
(ii) the prices are set by firms at t − 1 and are only effective in t. These are
expected to be the market clearing price in t, i.e. pt = Et−1 [p∗t ]
(iii) real output consistent with natural rate of unemployment, (y ∗ ), is determined
by the following law of motion that captures hysteresis
yt∗ = δ0 + δ1 t + δ2 yt−1
∗
+ ut
where t being time trend, δ0 , δ1 , δ2 positive parameters and ut is an i.i.d.

normal aggregate supply shock with ut ∼ (0, σu2 )
(iv) the monetary policy is characterised by the expression
mt = µ0 + µ1 mt−1 + et
where et is an i.i.d. normal money supply shock with et ∼ (0, σe2 ).
186
(a) Solve for the output gap, i.e. deviations of real output from the market
clearing level.
(b) Are unanticipated monetary policy changes effective? Show analytically and
provide intuition.
(c) Are anticipated monetary policy changes effective? Show analytically and
provide intuition.
(d) What is the Lucas critique? Evaluate the critique based on the output gap
equation you have derived above.
11. Suppose that the economy of Pool-land is characterised by the following IS schedule
Y = a − bR + ε
and the following LM schedule
M = c − dR + eY + η
where Y represents the real output, R the short term interest rate, M the real
money balances, coefficients a, b, c, d are positive constants. The economy is
subject to additive shocks. ε and η are IS and LM shocks with the following
properties ε ∼ i.i.d. (0, σε2 ) and η ∼ i.i.d. (0, ση2 ). Note that the uncertainty arises
only due to additive shocks.
Suppose that the monetary authority goal is to minimise the variance of output.
(a) Is it better to use short term interest rates instead of real money balances to
stabilise the economy when the economy is subject to IS shocks only? Show
analytically.
(b) Is it better to use short term interest rates instead of real money balances to
stabilise the economy when the economy is subject to LM shocks only? Show
analytically.
(c) Now consider the case of multiplicative uncertainty, where parameters of the
model, a, b, c, d are subject to uncertainty. Would this model modification
affect your policy results? Discuss verbally.
12. A treasurer has to manage the cash position of a small London college. At the
beginning of the year the college receives £5 million in tuition fees. The college is
expected to spend all of that money in the year, at an approximately constant
daily rate. The treasurer can either hold the financial wealth of the college in
bonds, yielding an interest rate of 4% or in cash, which is assumed to not receive
any interest. The accrued interest on the bond holdings is received at the end of
the year and is not compounded inbetween. The brokerage fees of exchanging
bonds for money are £1,000 per transaction. Note that the first transaction takes
place at the beginning of the year, when the treasurer buys bonds, the transactions
during the rest of the year will compose of selling bond holdings. The treasurer
wants to minimize the costs of cash management, C, which are composed of the
interest foregone on the cash holdings and the brokerage fees.
187
A. Sample examination paper
(a) Draw the time profile of the college’s holdings of cash and bonds.
(b) Set up the cost minimization problem for the treasurer and calculate the how
much money, Z, should be transferred each time the treasurer sells off bonds.
(c) Calculate the interest elasticity of money.
(d) The problem outlined above is based on the Baumol–Tobin inventory theoretic
model. State and discuss two criticisms of the inventory theoretic model.
13. Assume that the banking sector is described as follows:
D = d0 − d1 (i − iD ) (A.1)
L = l0 − l1 (i − iL ) (A.2)
where L stands for bank loans, D stands for bank deposits, iL the loan rate, iD
deposit rate and i is the market interest rate. Assume that banks do not have
operating costs or are not required to hold reserves.
(a) Calculate the competitive equilibrium. Show graphically. How do your results
change when the government sets deposit rates equal to iD = a, with a < iL ?
Provide intuition.
(b) Now suppose that government introduces a mandatory reserve ratio, r∗ , such
that R = r∗ D. How do your results change? What are the implications of such
a reserve ratio policy on prices and quantities? Provide intuition.
(c) Sometimes, it is suggested that the reserve ratio policy can be an alternative
to targeting interest rates or monetary aggregates. Can this be an effective
policy to stabilise output and inflation fluctuations?
END OF PAPER
188
Appendix B
Examiners’ commentary to Sample
examination paper
Section A
Answer ALL EIGHT questions from this section. (5 marks each)

Indicate whether the following statements are true or false, or uncertain and give a
short explanation. Points are only given for a well reasoned answer.
1. The advantage of using fiat money vs. a barter economy is that fiat money no
longer requires trust between transaction partners.
False.
Reading for this question: the subject guide, Chapter 2.
Direct barter is the only method of transaction that does not require trust. Fiat
money is intrinsically worthless: its value derives primarily from the trust that
people put in it (Trust Monetary authority/government). The advantages of fiat
money rather lie in the fact that it is durable, portable, homogeneous, and
acceptable.
2. The demand of money is positively related to the price uncertainty of assets.

True.
Higher uncertainty implies a higher opportunity cost of holding assets when agents
are risk averse, hence reducing the demand for assets and thus increasing the
demand for money.
3. Under the preferred habitat theory the slope of the yield curve tells us nothing
about the expected inflation.
False.
The PH Theory states that the yield of longer maturities is partially determined by
risk premia and partially by expectations about future short term interest rates.
Given a theory on the nature of risk premia (eg. half a percent per year of
maturity) and the relation between short term interest rates and inflation (e.g. real
interest rates are constant) one can use PH theory to make inference about
expected inflation.
189
B. Examiners’ commentary to Sample examination paper
4. In Tobin’s portfolio selection model individuals hold either money or bonds.

False.
Reading for this question:
1. The subject guide, Chapter 3.
2. Tobin, J. (1956), ‘The interest elasticity of transactions demand for cash’,
Review of Economics and Statistics, 38(3), pp. 241–47.
3. Tobin, J. (1958), ‘Liquidity preference as behaviour towards risk’, Review of
Economic Studies, 25(1), pp. 65–86.
Unlike the Keynesian model, where agents are assumed to hold either only money
or only bonds Tobin’s model explains why people hold both.
Tobin modelled the demand for money and bonds as a utility maximisation of a
portfolio of assets. Cash is assumed to have no risk and zero return, bonds positive
expected return and strictly positive risk. The portfolio is chosen such that it
maximizes a mean-variance utility function, which will normally yields a portfolio
containing both cash and risky assets. Note that for non-trivial diversification of
risk to take place, the number of risky assets in the portfolio should be strictly
larger than 1.
5. Parameter uncertainty in the Brainard model implies more aggressive fiscal policy
action.
False.
Reading for this question:
1. The subject guide, Chapter 12.
2. Brainard, W. (1967), ‘Uncertainty and effectiveness of policy’, American
Economic Review (papers and proceedings), 57 (2), pp. 411–425.
In Brainard’s model of multiplicative uncertainty it is shown that if there is
parameter uncertainty in the models the central bank uses, it will pursue a less
aggressive monetary policy objective. This happens because the government has to
trade off lower output volatility against higher output (as close to y ∗ as possible).
Due to the parameter uncertainty, choosing higher levels of y will result in a higher
level of output volatility. See Figure 12.2.
g2y∗
min X 2 σg2 + (y ∗ − gX)2 , gX = 2 2
< y∗.
X σg + g
6. The quantity theory of money states that the total value of all monetary
transactions must be equal to the real value of goods and services it buys.
False.
It refers to nominal rather than real value of goods and services it buys.
190
7. According to the standard real business cycle (RBC) theory, money is not neutral.
False.
Standard RBC suggests the opposite as an extension of the classical model. It is
based on the premise of a frictionless economy where all agents make optimal
decisions given their preferences and constraints. Money is just a veil.
8. Recessions are best dealt with by conservative central bankers.

False.
Literature on inflation bias and time consistency suggests that a conservative
central bank who is less concerned with output variations than society can reduce
the inflation bias. According to this literature, given that inflation/output
trade-offs are short term phenomena and agents rationally infer from the actions of
the central banks temptation to generate inflation to raise output in the short run
and act accordingly.
Section B
Answer THREE out of FIVE questions from this section. (20 marks each)
9. Consider a classical-Patinkin economy where a representative household utility is a

function of consumption (C) and real money balances (M/P ) such that:
U = C α (M/P )1−α
and the household is subject to a budget constraint given by:
C + M/P ≤ Y + M0 /P
where Y stands initial endowment of goods, M0 stands for initial money balances.
(a) Calculate optimal goods and money demand. Provide intuition. Would your
results change qualitatively if elements (that are real money balances and
consumption) in the utility function were additive, instead of multiplicative?
(b) Is there a role for monetary policy in this setting? What happens when the
economy faces a money supply increase? Show graphically and provide
intuition.
(c) Is the classical theory convincing? Are you aware of alternative macro theories
where monetary policy can be an effective output stabilisation tool? Discuss
analytically one such model.
191

(a) Here we assume that the utility depends not only goods consumption but also
on the level of real money balances. The justification, due to Patinkin, is that
even if households plan to balance their budgets so that planned purchases are
equal in value to planned sales, it may be convenient to buy and sell goods at
different times. The more money they hold, the greater the extent to which
they can purchase goods ahead of making sales. Money holdings stand as a
proxy for the more convenient sequence of transactions they make possible.
Thus, money is in the utility function.
Assume a household’s utility depends on the quantity of goods consumed, X,
and on real money balances, M/P . Let the household have initial endowments
Y of goods and M0 of nominal money balances. The budget constraint faced
by the household is then, in nominal terms:
P X + M ≤ P Y + M0 . (B.1)
So that the nominal expenditure on goods, P X, plus the holdings of nominal

money balances, M , must not be greater than the nominal value of the
endowments of goods and money. Writing the budget constraint in real terms
(dividing by the price level) gives:
M M0
X+ ≤Y + . (B.2)
P P
For the sake of simplicity we assume that α ≤ 1/2. Then, the household’s
utility function takes the specific form U = X 1/2 (M/P )1/2 . In order to
determine the demands for goods and real money balances, we maximise the
utility function subject to the budget constraint. To do this we form the
Lagrangian:1
1/2
1/2 M M0 M
L=X +λ Y + −X − . (B.3)
P P P
Differentiating with respect to the two choice variables, X and M/P , gives the
first order conditions of:
1/2
∂L 1 −1/2 M
= X −λ=0 (B.4)
∂X 2 P
−1/2
∂L 1 1/2 M
= X −λ=0 (B.5)
∂(M/P ) 2 P
from which we obtain
M
X= (B.6)
P
Substituting into the budget constraint will give solutions for the demands for
goods and nominal money balances of:
Y + M0 /P P Y + M0
X= and M= . (B.7)
2 2
1
We also impose an equality in the budget constraint as this implies no wastage of goods or money.
192
Assume now that the economy consists of n households each identical to the
one described above. The market clearing condition in the goods market then
becomes:
Y + M0 /P
n = nY. (B.8)
2
In other words, total demand equals total supply. Solving for the price level
gives:
M0
P = . (B.9)
Y
Alternatively, we can write down the market clearing condition for the money
market:
P Y + M0
n = nM0 . (B.10)
2
If we solve for the price level here, we obtain:
M0
P = . (B.11)
Y
In this economy, money is neutral. Real output per household is fixed at Y as
it depends on endowments.
Modifying the utility function such that elements are additive (i.e. such that
U = X 1/2 + (M/P )1/2 ) does not change result.
(b) From the solution of the price level, a change in the money supply will only
lead to a proportional increase in prices. Real money balances and ‘production’
of goods do not change. An increase in money, M0 , will shift the demand
function for good X outwards in Figure 4.2 but this simply causes the price
level to increase.
(c) In standard classical models money is just a veil, while we know that money
may have real effects at least in the short run. However, it is possible even
with the classical paradigm to obtain short term real effects of money. There
are a wide range of alternatives here. Students could solve Lucas’
misperceptions model or a simple cash in advance model for cases of classical
model or a Keynesian (such as McCallum) model to make their point.
10. Consider a McCallum economy with sticky prices where the aggregate demand
expression given as:
yt = β0 + β1 (mt − pt ) + β2 Et−1 [pt+1 − pt ] + vt
where yt , mt and pt are the logs of real output, nominal money balances and the
price level respectively at date t, vt is an i.i.d. normal aggregate demand shock with
vt ∼ (0, σv2 ) are positive parameters and E is the expectations operator. To
construct the aggregate supply assume the following:
(i) the market clearing price is denoted by p∗t
(ii) the prices are set by firms at t − 1 and are only effective in t. These are
expected to be the market clearing price in t, i.e. pt = Et−1 [p∗t ]
193
(iii) real output consistent with natural rate of unemployment, (y ∗ ), is determined

by the following law of motion that captures hysteresis
∗
yt∗ = δ0 + δ1 t + δ2 yt−1 + ut
where t being time trend, δ0 , δ1 , δ2 positive parameters and ut is an i.i.d.

normal aggregate supply shock with ut ∼ (0, σu2 )
(iv) the monetary policy is characterised by the expression
mt = µ0 + µ1 mt−1 + et
where et is an i.i.d. normal money supply shock with et ∼ (0, σe2 ).
(a) Solve for the output gap, i.e. deviations of real output from the market
clearing level.
(b) Are unanticipated monetary policy changes effective? Show analytically and
provide intuition.
(c) Are anticipated monetary policy changes effective? Show analytically and
provide intuition.
(d) What is the Lucas critique? Evaluate the critique based on the output gap
equation you have derived above.
Reading for this quesiton: the subject guide, Chapter 9 and McCallum (1989),
Chapters 9 and 10.
(a) First consider aggregate demand. By combining the IS and LM equations, we
can derive an AD expression of the form:
yt = β0 + β1 (mt − pt ) + β2 Et−1 [pt+1 − pt ] + vt . (B.12)
yt , mt and pt are the logs of real output, nominal money balances and the
price level, respectively, at date t. vt is a random demand shock with zero
mean (i.e. an element of aggregate demand that is not picked up by real
money balances or expected inflation). β0 , β1 and β2 are positive parameters
and Et−1 is the rational expectations operator with the t − 1 subscript
denoting the date the expectation was formed. In rational expectations, people
not only take all available information into account when they form their
expectations, but their expectations are also consistent with the way in which
the variables actually evolve. Rational expectations are sometimes also known
as ‘model consistent’ expectations.The equation states that aggregate demand
depends positively on real money balances and positively on expected
inflation; for any given nominal interest rate, higher inflation implies a lower
real interest rate, making investment cheaper.
Aggregate supply is a little more difficult to specify because of the assumption
that prices are set at the beginning of the period, with supply being demand
determined. Denote the price that clears the market at date t as p∗t . We assume
that the prices the firms set at date t − 1, to be operational in the market at
date t, pt , are the prices they expect to clear the market at date t, i.e.:
pt = Et−1 [p∗t ]. (B.13)
194
Also, denote the output level that clears the market at date t as yt∗ . Then, if
the price equals that which allows markets to clear, by definition markets must
clear and so yt∗ must equal the demand when pt = p∗t .
yt∗ = β0 + β1 (mt − p∗t ) + β2 Et−1 [pt+1 − p∗t ] + vt . (B.14)
Rearranging (7.8) to obtain p∗t on the left-hand side gives:
β0 − yt∗ + β1 mt + β2 Et−1 [pt+1 ] + vt

p∗t = (B.15)
β1 + β2
noting that Et−1 [p∗t ] equals pt from (B.13) and that in the situation of market
clearing, pt = p∗t . We now need an expression telling us how the market
clearing/full employment level of output, yt∗ , evolves over time. Here we will
generalise the process used in McCallum (1989) so that yt∗ increases gradually
through time but also depends positively on last period’s full employment
output level. This is commonly known as a hysteresis term, which allows
persistence of full employment output. If full employment output is high today,
it is likely to be high tomorrow.
yt∗ = δ0 + δ1 t + δ2 yt−1
∗
+ ut . (B.16)
ut is a zero mean, random supply, shock, which could include the discovery of
oil reserves or other raw materials or a sudden technological breakthrough that
can increase the productive capacity of the economy.
(B.13), (B.15) and (B.16) together can be regarded as constituting aggregate
supply. Along with aggregate demand, (B.12), we can solve for the output
level, yt , in terms of deviations from yt∗ , and also for the price level, pt . The
solution method is given in McCallum, Chapter 10, and you should read the
relevant section in order to see how the solution is derived. However, a brief
outline is given below.
Take expectations of (B.16) conditional on information available at date t − 1:
Et−1 [yt∗ ] = δ0 + δ1 t + δ2 yt−1

∗
⇒ Et−1 [yt∗ ] = yt∗ − ut . (B.17)
Do the same for (B.14), noting that Et−1 [vt ] = 0:
Et−1 [yt∗ ] = β0 + β1 Et−1 [mt − p∗t ] + β2 Et−1 [pt+1 − p∗t ]. (B.18)
Equating (B.17) and (B.18), noting that Et−1 [pt+1 − pt ] in (B.18) is equal to pt
(from (B.13)) gives:
yt∗ = β0 + β1 (Et−1 [mt ] − pt ) + β2 (Et−1 [pt+1 ] − pt ) + ut . (B.19)
If we subtract (B.19) from (B.12), we will have an expression for yt − yt∗ (i.e.
deviations of output from the market clearing level).
yt − yt∗ = β1 (mt − Et−1 [mt ]) + vt − ut . (B.20)
195
(b) Imagine that the money supply set by the authorities changes according to:
mt = µ0 + µ1 mt−1 + et (B.21)
where et is a zero mean, random error representing monetary policy shocks.

Taking expectations of (B.21) conditional on information at date t − 1 will give
us an expression for the unexpected money supply at date t, mt − Et−1 [mt ],
which simply equals et . Substituting this into (B.20) will give us a solution for
the output deviation, yt − yt∗ .
yt − yt∗ = β1 et + vt − ut . (B.22)
Notice that the systematic component of monetary policy (µ0 + µ1 mt−1 ) does
not have any real effects here. This is because at date t − 1, when prices for
date t are set, firms take into consideration what they expect the monetary
authorities will do. If they expect the money supply to increase, knowing that
money should have no real effects, they will increase their prices for date t
accordingly. Only the random component of monetary policy, the monetary
policy shock et , will have real effects since this is realised after the prices have
been set. This result, that the systematic component of monetary policy has
no real effect, will be discussed in more detail in the next chapter, in the
section ‘policy ineffectiveness proposition’.
(c) The Lucas critique refers to the instability of reduced-form expressions used
for policy making or policy appraisal. In the sticky price model of Chapter 9,
the structural equations were given by the aggregate demand equation, the
price equation, pt = Et−1 [p∗t ] the equation showing how yt∗ evolves and the
monetary policy reaction function showing how mt depends on the state of the
economy. When we solve for yt − yt∗ , the equation we derive is a reduced-form
equation; a mixture of aggregate demand, aggregate supply and the
authorities’ reaction function. For example, consider the sticky price model
and the reduced-form expression, (B.22), yt − yt∗ = β1 et + vt − ut . Instead of et ,
write mt = Et−1 [mt ] = mt − µ0 − µ1 mt−1 .
yt − yt∗ = −β1 µ0 + β1 mt − β1 µ1 mt−1 + (vt − ut ). (B.23)
If this equation were given to an econometrician, he or she would run a

regression of the form:
yt − yt∗ = γ0 + γ1 mt + γ2 mt−1 + η1 (B.24)
and would find a positive coefficient for γ1 since we know γ1 = β1 (only if the
economy was accurately represented by the structural equations given above!).
Since γ1 > 0, we may then think that an increase in the money supply should
cause an increase in output above yt∗ . For example if γ1 was found to equal 0.5,
then increasing the money supply by 2% should cause a 1% increase in output.
However, as we saw in Chapter 7, the systematic component of monetary
policy had no real effects. Even though we may think an increase in the money
supply will increase output (from the reduced form equation, (B.24)), in
reality the change in people’s expectations associated with this policy change
will cause the reduced form to break down. If the authorities increased the
196
money supply by increasing µ0 , indeed this will have a positive effect on
output, via γ1 , but it will also have a negative effect on output since
γ0 = −β1 µ0 . The effect of an expansionary monetary policy will be purely
inflationary. Quoting Romer (2001) p.251,
‘If policymakers attempt to take advantage of statistical
relationships, effects operating through expectations may cause the
relationships to break down. This is the famous Lucas critique.’
11. Suppose that the economy of Pool-land is characterised by the following IS schedule
Y = a − bR + ε
and the following LM schedule
M = c − dR + eY + η
where Y represents the real output, R the short term interest rate, M the real
money balances, coefficients a, b, c, d are positive constants. The economy is
subject to additive shocks. ε and η are IS and LM shocks with the following
properties ε ∼ i.i.d. (0, σε2 ) and η ∼ i.i.d. (0, ση2 ). Note that the uncertainty arises
only due to additive shocks.
Suppose that the monetary authority goal is to minimise the variance of output.
(a) Is it better to use short term interest rates instead of real money balances to
stabilise the economy when the economy is subject to IS shocks only? Show
analytically.
(b) Is it better to use short term interest rates instead of real money balances to
stabilise the economy when the economy is subject to LM shocks only? Show
analytically.
(c) Now consider the case of multiplicative uncertainty, where parameters of the
model, a, b, c, d are subject to uncertainty. Would this model modification
affect your policy results? Discuss verbally.
(a,b) (Note: Here, parts a and b are analysed together.) Uncertainty over the
structure of the economic model, or reduced-form model instability, which
manifests itself through the Lucas critique, is one form of model uncertainty
that the monetary authorities must consider when deciding on policy.
Poole (1970) analysed the implication of adding shocks to both the IS and LM
schedules. Such shocks could come about from trade union strikes or wars on
the IS side and stock market crashes and financial crises such as the collapse of
LTCM in 1998 on the LM side. Poole’s model assumes that the parameters
and structure of the model are known with certainty, which is an unrealistic
assumption, but allows the IS and LM schedules to be subject to zero-mean
random errors. The schedules can be described by (B.25).
Y = a − bR + ε (B.25)
M = c − dR + eY + η.
197
ε and η are additive IS and LM shocks whose variances are σε2 and ση2
respectively, and for simplicity we ignore the price level in the LM curve.
Alternatively, assume the monetary authorities can control real money
balances, denoted by M . The authorities can either set the money supply, M ,
or the interest rate, R, but not both. With a downward-sloping money demand
schedule, either R or M can be set and the other variable will have to change
to allow the markets to clear. If the authorities set the interest rate, then from
the IS schedule, the expected value of output, Y , given R, denoted E[Y ] |R will
be:
E[Y ] |R = a − bR. (B.26)
Assume that the goal of the policymakers is to minimise the variance of
output. From (13.29) and (13.30), Y − E[Y ] |R will simply be ε and so the
variance of output given that the authorities set the interest rate will be
E[Y − E[Y ] |R ]2 = σε2 . Alternatively, the monetary authorities could set the
money supply, M . In order to calculate the variance of output in this scenario,
we need to calculate Y as a function of M only. From the LM schedule, we can
calculate R as a function of M , Y and η and then substitute this into the IS
curve. Solving for Y will give:
ad − bc bM dε − bη
Y = + + . (B.27)
d + be d + be d + be
We can then find E[Y ] |M and the variance of output given that the authorities
directly control the money stock. This is given in (13.32).
2
2 1
E[Y − E[Y ] |M ] = (d2 σε2 + b2 ση2 ). (B.28)
d + be
We can now examine which policy instrument, when set by the authorities,
will result in a lower output variance. Consider the case where there are no IS
shocks, σε2 . The variance of output under both interest rate and money
targeting regimes is given in the top line of Table B.1. It is clear that setting
the interest rate and allowing money to change to clear the market is the
optimal strategy. However, if there are no LM shocks, ση2 , then output variance
is smaller under a policy of fixed money supply, see the bottom line of Table
B.1. Therefore, if an economy is prone to IS shocks, the authorities should
keep the money supply constant. If the economy is prone to money market,
LM, shocks, the interest rate should be the instrument of choice.
b
2
Only LM shocks, σε2 = 0 Var[Y | R] = 0 < Var[Y | M ] = d+be
ση2
d
2
Only IS shocks, ση2 = 0 Var[Y | R] = σε2 > Var[Y | M ] = d+be
σε2
Table B.1:
This is also shown in the subject guide Figures 12.1a and 12.1b. Figure 12.1a
shows the case with IS shocks only. The output variation when the interest
198
rate is fixed at R∗ is shown by DY |R , in which case the money supply has to
change to clear the money markets causing the LM curve to shift so that
equilibrium is at points A or B. If the money supply was kept fixed then
output deviations are shown by DY |M . Therefore, with IS shocks, in order to
keep output variance at a minimum, it is best to keep the money supply fixed.
In Figure 12.1b, by keeping the interest rate fixed after LM shocks, equilibrium
will be unchanged at point E and output variance will therefore be zero. By
keeping the money supply fixed, however, LM shocks will cause equilibrium to
move between points A and B and output variance will be positive, equal to
∆Y |M . So, depending on the main source of economic shocks, whether they
originate from the goods or money markets, will determine which monetary
instrument the authorities should target.
(c) Whereas Poole considered the case where shocks were additive in nature,
Brainard (1967) examined the case where the values of the parameters in the
model were not known with certainty. This is, arguably, more realistic since
any model must be estimated from data. An estimated model will not only
give point estimates of the parameters but will also give standard errors since
there will always be measurement error, model mis-specification and other
problems that cause us not to know the exact structure of the economic model.
Suppose output, y, depends on a policy mix, X, a vector containing fiscal and
monetary instruments that the government can control. The relationship
between y and X is given by:
y = gX. (B.29)
For simplicity, assume X is a single policy instrument so that g is a scalar
parameter estimate with mean gb and variance σg2 . The aim of the authorities is
to minimise the variance of y around some target level, y ∗ , full employment
level of output for example, subject to the constraint (B.30), i.e.
min E[y − y ∗ ]2 s.t. y = gX. (B.30)
If y = gX, taking averages will give yb = gbX. The problem can then be written
as:
min E[(y − yb)X − (y ∗ − yb)]2 s.t. y = gX
⇒ min E[(g − gb)X − (y ∗ − gbX)]2
⇒ min E[(g − gb)2 X 2 + (y ∗ − gbX)2 − 2(g − gb)X(y ∗ − gbX)]. (B.31)
Noting that E[g − gb]2 = σg2 and that E[g − gb] = gb − gb = 0, the problem then
becomes:
min X 2 σg2 + (y ∗ − gbX)2 . (B.32)
X
Differentiating this with respect to X, the choice variable, setting equal to zero
and solving will give:
gby ∗ gb2 y ∗
X= ⇒ yb = gbX = < y∗. (B.33)
σg2 + gb2 σg2 + gb2
199
The implication of the model is that because of the presence of uncertainty,

σg2 > 0, the authorities will never push aggressively enough to make average
output equal to the target level, y ∗ . To do so will simply cause output
variation to increase to an intolerable level. The policy maker would rather
have a stable level of output below the full employment level than very volatile
output whose average was y ∗ . This is shown in the subject guide Figure 12.2.
From y = gX and yb = gbX, it follows that σy2 = σg2 X 2 which implies
X = σy /σg . Substituting into y = gX will give the linear policy constraint in
Figure 12.2. The authorities try to reach the indifference curve closest to y ∗ ,
the target level, subject to the policy constraint and as can be seen in Figure
12.2, the presence of uncertainty, σg2 , causes the authorities to opt for a less
aggressive policy stance, causing equilibrium output to be below y ∗ .
12. A treasurer has to manage the cash position of a small London college. At the
beginning of the year the college receives £5 million in tuition fees. The college is
expected to spend all of that money in the year, at an approximately constant
daily rate. The treasurer can either hold the financial wealth of the college in
bonds, yielding an interest rate of 4% or in cash, which is assumed to not receive
any interest. The accrued interest on the bond holdings is received at the end of
the year and is not compounded inbetween. The brokerage fees of exchanging
bonds for money are £1,000 per transaction. Note that the first transaction takes
place at the beginning of the year, when the treasurer buys bonds, the transactions
during the rest of the year will compose of selling bond holdings. The treasurer
wants to minimize the costs of cash management, C, which are composed of the
interest foregone on the cash holdings and the brokerage fees.
(a) Draw the time profile of the college’s holdings of cash and bonds.
(b) Set up the cost minimization problem for the treasurer and calculate the how
much money, Z, should be transferred each time the treasurer sells off bonds.
(c) Calculate the interest elasticity of money.
(d) The problem outlined above is based on the Baumol–Tobin inventory theoretic
model. State and discuss two criticisms of the inventory theoretic model.
(a) See Figure 3.2 in the subject guide.
(b) We have
min C = 1,000 × 5,000,000/Z + 0.04Z/2

z
= 5,000,000,000/Z + 0.02Z.
The first order condition gives
5,000,000,000Z −2 + 0.02 = 0
p
Z = 5,000,000,000/0.02
Z = £500,000.
200
(c) Interest elasticity of money is defined as ∂ ln M/∂ ln i.
p
M = Z/2 = bT /2i
ln M = 0.5 ln b + 0.5 ln T − 0.5 ln i − 0.5 ln 2
∂ ln M/∂ ln i = −0.5.
(d) A good answer points out that the inventory theoretic model does not hold
well in practice. Two criticism are that the model assumes (1) perfect
information about the pattern of expenditures and (2) does not take into
account institutional factors. This leads the model to predict that firms hold
very little cash, much less than empirically observed.
13. Assume that the banking sector is described as follows:
D = d0 − d1 (i − iD ) (B.34)
L = l0 − l1 (i − iL ) (B.35)
where L stands for bank loans, D stands for bank deposits, iL the loan rate, iD
deposit rate and i is the market interest rate. Assume that banks do not have
operating costs or are not required to hold reserves.
(a) Calculate the competitive equilibrium. Show graphically. How do your results
change when the government sets deposit rates equal to iD = a, with a < iL ?
Provide intuition.
(b) Now suppose that government introduces a mandatory reserve ratio, r∗ , such
that R = r∗ D. How do your results change? What are the implications of such
a reserve ratio policy on prices and quantities? Provide intuition.
(c) Sometimes, it is suggested that the reserve ratio policy can be an alternative
to targeting interest rates or monetary aggregates. Can this be an effective
policy to stabilise output and inflation fluctuations?
Reading for this question: the subect guide, Chapter 4.
(a) Competitive equilibrium: The profits made by the bank will equal the quantity
of loans, L, multiplied by the interest earned on those loans, iL (which is the
bank’s revenues) minus the costs faced by the bank. Costs will equal the
interest paid to depositors in order to encourage them to hand over their funds
to the bank. Costs then equal the quantity of deposits, D, times the interest
rate paid on deposits, iD . Noting that in a competitive equilibrium, profits
equal zero:
Π = LiL − DiD and Π = 0.
When making the additional assumption that the bank holds no reserves, in
order for the bank’s balance sheet to balance and convenience assumption that
constants d0 = l0 , loans (assets) must equal deposits (liabilities), L = D.
Substituting implies that in equilibrium:
iD = iL
201
Substituting into bank condition and equating L with D gives:

d0 − d1 (i − iD ) = d0 + l( i − iD ).
Solving for the interest rate on deposits, which equals the interest rate charged
on loans gives:
iD = iL = i.
This implies total deposits, D, which equals total loans, L, equals d0 . In
equilibrium, the interest rate paid on deposits equals the interest rate charged
on loans, which equals the market interest rate, i. The level of deposits, which
in this model is equal to the level of the money stock,equals the amount of
loans. (See e.g. Figure 4.1 in the subject guide.)
Government regulation of the deposit rate: One way that the government
could reduce or control the money supply is by setting a limit on the interest
rate paid on deposits. If the maximum interest rate banks can pay on deposits
is less than i in the above example, then the amount of funds savers are willing
to deposit with the bank will fall, resulting in a lower money supply. Note that
this will also be associated with a lower quantity of loans that, despite the
lower money supply, may be harmful to the economy if it means some
investment opportunities are not undertaken. Consider the case where the
government sets the interest rate on deposits equal to zero. From deposit
condition, the quantity of deposits is fixed at D = d0 − d1 i. Diagrammatically,
this is shown in Figure 4.2 in the subject guide.
The level of deposits, and hence of the money supply, has fallen from d0 to
d0 − d1 i because of the government regulation. Since deposits must equal loans
in order for the bank’s balance sheet to balance, the lower level of deposits
means a lower level of loans, which is associated with a higher interest rate
charged, iL > i. Also, since there is a difference between the interest rate
charged on loans and that paid on deposits (which has been set at zero), the
government regulation has allowed the banks to make positive profits.
(b) Assume that the government introduces a mandatory reserve ratio, r∗ (i.e.
total reserves of the bank, R, equals r∗ times D). The bank’s assets now
comprise loans, as before, but now include these reserves. Its liabilities are just
the deposits of its customers. Since Assets = Liabilities, we can write:
r∗ D + L = D and L = (1 − r∗ )D.
Substituting this into the zero profit condition and rearranging will give the
interest rate charged on loans to be:
iL = iD /(1 − r∗ ) > iD .
The interest rate charged on loans is now higher than the interest rate paid on
deposits. This is in order to compensate the banks for holding reserves, on
which it earns no interest. Total loans are now less than total deposits so each
dollar lent out must earn a higher return than that paid on each dollar
deposited with the bank. iL then needs to be greater than iD .
By changing the mandatory reserve ratio, the government can change the total
money supply through the activities of the banking sector. However, the way
202
in which D varies with r∗ is uncertain and depends on the parameters of the
model. With no reserve requirements we equate L to D in order for the bank’s
balance sheet to balance. In this situation we equate L to (1 − r∗ )D. Therefore
the new intersection results in a lower value of L but a higher interest rate
charged, iL . Total revenues for the bank, L times iL , could then increase or
decrease depending on the elasticity of the demand for loans function. If the
demand for loans is elastic then, if L falls, revenue will fall. Banks will be
forced to cut the interest paid on deposits, so iD falls, resulting in fewer
deposits and hence causing the money supply to fall. If the demand for loans is
inelastic, a fall in L, caused by the reserve ratio, will increase revenues. The
banks will increase iD and so total deposits will increase.
(c) Unlikely for several reasons. First, such it is extremely cumbersome to
implement reserve policy in relatively high frequency (say, monthly). Second,
its effectiveness depends on the loan demand elasticity. Even under the
assumption of time invariant elasticity, given the variety of loans offered in the
banking system, it is very hard too anticipate the effects of the monetary
policy on the transmission channels. Finally, it is a rather difficult one to
communicate the policy changes to wider society, thus harming the
transparency aspects of monetary implementation.
203
204
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Monetary economics

University of London International Programmes

Published by: University of London

1 Introduction to the subject guide 7

2 The nature of money 17

3 The demand for money 29

4 The supply of money 43

5.3 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

7 Money, inflation and welfare 85

7.8 A reminder of your learning outcomes . . . . . . . . . . . . . . . . . . . . 96

8 Classical models and monetary policy 101

9 Keynesian models with money supply as a policy instrument 119

10 New Keynesian models of monetary policy 137

10.2 Aims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

11 Time inconsistency and inflation bias 151

12 Monetary policy and data/parameter uncertainties 161

12.5 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

13 The term structure of interest rates 175

A Sample examination paper 185

B Examiners’ commentary to Sample examination paper 189

1.1 The structure of the guide

1.2 The subject guide and the syllabus

1.3 Specifics of the syllabus

Section 1: Introduction to money and monetary economics

The nature of money:

Microeconomic determinants of the demand for money and macroeconomic money

The Classical dichotomy, Walras’ and Say’s laws, introduction to money in a

Section 2: Monetary policy

Stylised facts and monetary policy:

Trends and business cycles. Means, volatility, cyclicality and persistence in

Neutrality and superneutrality of money, welfare costs, seigniorage and the

Section 3: Topics in monetary economics

Time inconsistency in monetary policy:

Uncertainties in the monetary policy design:

News versus noise in data revisions. Brainard conservatism, certainty equivalence,

Explanation of the yield curve: expectations hypothesis and the segmentation

develop understanding of the theories that relate to the existence of money,

develop an understanding of the monetary transmission mechanism, whereby

develop a number of macroeconomic models through which monetary policy can be

develop understanding of the uncertainties policy-makers face and how policy

1.5 Learning outcomes

1.6 Subject chapters

1.7 Reading advice

Unfortunately no single textbook adequately covers the whole of the EC3115

1.8 Essential reading

Carlin,W. and D. Soskice Macroeconomics: Imperfections, Institutions and Policies.

Cagan, P. ‘The monetary dynamics of hyperinflation’, in Friedman, M. (ed.)

Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan,

Lucas, R.E. ‘Econometric policy evaluation: a critique’, in Brunner, K. and A.H.

McCallum, B. Monetary Economics. (New York: Macmillan; London: Collier

Williamson, S. Macroeconomics. (New Jersey: Prentice Hall, 2013) fifth edition

Bernanke, B. , Gertler, M., and S. Gilchrist (1999) ‘The financial accelerator in a

Carlin, W. and D. Soskice ‘The 3-equation New Keynesian model – A graphical

Lucas, R., ‘Some international evidence on output-inflation trade-offs’, American

Plosser, C., ‘Understanding real business cycles’, Journal of Economic Perspectives

1.9 Further reading

1.10 Online study resources

Past examination papers and Examiners’ commentaries: These provide advice on

1.11 How to use this subject guide