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

Monetary Economics II: Theory and Policy
ECON 3440C
Tasso Adamopoulos
York University
Fall 2021
Lecture 7
ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 1 / 38

1. The Lucas Model

Environment
Standard OLG model of money.
Assumption: individuals live in two spatially separated island (distinct

markets).
Total population N across the two islands is constant over time.
Half (1/2) of the old individuals in any period live on each of the two
islands.
The old are randomly distributed across the two islands,

independently of where they lived when young → implies you do not
know where you will be next period.

Environment
The young are unequally distributed across the two islands,
I 2/3 of the young live on one island
I 1/3 of the young live on the other island
In any single period, each island has an equal chance (1/2) of having
the large population of young.
The outcome of this random assignment of the population has no
effect on the outcome in any other period.
The stock of fiat money grows according to,
Mt = zt Mt−1
Note: zt is time-varying (random variable)
Increases in the stock of fiat money are given to the old as lump-sum
subsidies per person,

1 vt Mt
at = 1 −
zt N
N old N old
I
3N young f N
young
Environment - informational assumptions
In any given period,the young can directly observe neither the number
of young people on their island N i , nor the size of the subsidies to the
old at (i.e, zt ).
The nominal stock of fiat money balances is known with a delay of

one period, i.e., in t you know Mt−1 but not Mt .
The price of goods on an island pti is observed but only by the people
on that island.
No communication between islands is possible within a period (you

need this otherwise they could infer zt from central market clearing).

Environment - expectations
Rational expectations.
Individuals know the possible outcomes they face and the probabilities
of each outcome.
Individuals make the best possible inference given the information

they have (i.e., price pti ).

Re-interpretation of individual problem in OLG
When young people are endowed with y units of time.

I y = time endowment of the young
The young can allocated their time between leisure - denoted c1 , and
work/labour - denoted `.
When they young work they produce goods, which they sell to the old
in exchange for money.
They then carry that money over to the next period and use it to
purchase the market good c2 in that period.

Individual problem in OLG
The young work (give up leisure) to produce goods to sell to the old.
Let ìt = ` pti represent the choice of labour by an individual born in

period t, for a given price of goods pti on island i.
Technology for producing goods:

each unit of labour produces 1 unit
of goods → implying that ` pti also represents the individual
production of goods.
Note: the amount of labour supplied by an individual depends on the

price the individual receives on the goods produced.

Individual budget constraints
Individual budget constraint when young in period t on island i,

i
c1,t + ìt = c1,t
i
+ vti mti = y
where superscript i denotes island on which individual is born.
Labour is paid in money, mti = ìt pti
... which has value equal to real balances vti mti = ìt .
vti mti = a young individual’s holdings of fiat money in terms of the

consumption good (real demand for money) = amount of goods
individual produces and sells on the market ìt

Individual budget constraints
Money holdings and lump-sum government transfers serve to finance

consumption of the old.
Budget constraint of an old person on island j in period t + 1,

j
! !
v p i
ij j t+1 t
c2,t+1 = vt+1 mti + at+1 = ìt + at+1 = ìt + at+1
vti j
pt+1
Second period consumption depends on island i where the individual

is born, and on island j where the individual is randomly assigned
when old.
pti
j = real rate of return to work: if you work 1 unit of time and
pt+1
produce 1 good, selling it you receive price pti today, which allows you
i
to buy pj t in period t + 1.
pt+1

Problem of individual
Choose how much to work when young ìt to maximize their Expected
Utility for a given local price pti .
Preferences are restricted to the case in which the substitution
i
effect
(S.E.) of an increase in the real rate of return to work (↑ pj t )
pt+1
dominates the income effect (I.E.).
I S.E.: a high relative price of goods encourages output.
I I.E.: a higher relative price of goods makes people wealthier and thus
more desirous of reducing work in order to consume more leisure.
pti
This implies that as ↑ j individuals will choose to work more ↑ ìt .
pt+1
j
For a given future price of goods pt+1 , the higher the current price of
pti
goods pti , the higher the real rate of return to labor j → an
pt+1
increase in the current price of goods pti , other things equal, will
induce the young to work more ↑ ìt .
2. Non-random inflation
in the Lucas Model

Non-Random Inflation
Money stock grows at a fixed rate zt = z in all periods (anticipated

inflation).
Individuals can determine the current money stock Mt by multiplying

Mt−1 (which they know by assumption) by the anticipated z:
Mt = zMt−1 .
vti mti = ìt = ` pti = each young person’s demand for fiat money in

period t.
N i ` pti = total demand for fiat money on island i (since N i young)


Market Clearing on island i
Given that the old are equally distributed between the two islands
(regardless of birth place), and this is done every period, half of the
stock of fiat money ends up on each of the two islands, Mt /2.
vti M2t = total real supply of fiat money in period t on island i.
Market clearing condition for fiat money in terms of goods,

Mt
N i ` pti = vti

2

Implied prices
Since vti = 1/pti we can re-write the market clearing condition,
Mt /2
N i ` pti =
pti
We can then solve implicitly for the price level on island i,
Mt /2
pti =
N i ` pti

Note, that depending on whether island i has a small or large number

of young the possible values for N i are: 31 N and 23 N.
Because the population of the young on each island is the only

random variable, the market clearing condition implicitly expresses the
price level as a function of the population of young N i .
Therefore, observing the price of goods pti allows all of the young to
infer the number of young on their island.
Implied prices
Define prices,
I ptA = price of goods when population of young is small, N A = 31 N
I ptB = price of goods when population of young is large, N B = 32 N
Then,
Mt /2 M /2
ptA = = 1 t A
N A ` ptA 3 N` pt
Mt /2 Mt /2
ptB = = 2
N ` ptB
B

B
3 N` pt
Notice that, ptA > ptB , i.e., the price of goods is high when the
population of young is low.

Appendixtt
Prove by contradiction the claim that
PTA pets
Pt
Assume that PTA E pets
since the SE dominates the IE we have
lepe't E l CPGB
multiply both sides by IN

IN l CPe't E
f l PTB
but since Ig L we have
N l ta t NlcpeB
the last two inequalities imply

N left't s Zz Ml Cpt
this in
turn implies
I 1
Nl CPH Nlcpt's
Ig Eg
multiply both sides by Mtz

Me 12 MHz
f Nlc pea
f N leptB
M
since
by definition pei
Niecpei
Pt pets
but this contradicts our
original assumption that

Pelt E PeB original assumption
is wrong
Outcomes on each island
The price of goods is driven by the scarcity of young people producing

goods.
j
Because the price of goods in the next period pt+1 is independent of
i i
the price of goods this period pt , the greater pt the greater the rate
j
of return to producing goods, pti /pt+1 .
Low population of young 13 N → few young producing for the old →

high demand for each young’s product → high current price pti →
j
high real rate of return to labour pti /pt+1 →
people work more because SE dominates IE →
each young person produces more ìt .
Similarly when the population of young is high, the current price is

low, and each young produces little.

Outcomes on each island
Of course, because there is always one island with 32 N young and

another with 13 N young people, aggregate output does not depend on
which of the two islands has the larger number of young.
Prices here do the job we expect them to do in market economies:

they signal the true state of the world to people, so that they can
choose the quantity of their work/output that maximizes their well
being, given their true situation.

Effect of money increases on output - level
Will the young react to high prices in the same way, i.e., by ↑ ìt if
they know the high prices are caused by a once-and-for-all higher
level of fiat money stock? No!
Real rate of return to work,

Mt /2

j
j
vt+1 pti N i `(pti ) N j ` pt+1 Mt
= = =
vti j i

Mt+1 /2 i
N ` pt M
pt+1 j
t+1
N j `(pt+1 )
A permanent increase in the money stock raises both Mt and Mt+1

by the same proportion and so fails to affect the relative price of
goods in this period and the next.
A high current price caused by a permanent increase in the money

stock does not affect the rate of return to labour and thus the desire
to work → money is neutral in this case.
Effect of money increases on output - growth rate
What is the effect of anticipated inflation z on work? Is money

super-neutral? No!
With Mt+1 = zMt as ↑ z we have ↓ MMt+1 t

= z1 and thus from the rate
of return equation, the real rate of return to work falls → discourages
work because money balances earned from work are taxed by the
expansion of the money supply → fall in aggregate output.
Note: this happens on both islands at the same time.
This implies that if I compare two different economies with different

fixed z’s the economy with the higher z will have lower aggregate
employment and output.

This implies a negative correlation between inflation and aggregate

output (employment) across economies with different but constant
rates of fiat money expansion z.
Note: this result appears in contrast to the Phillips curve, which

predicted a positive relationship between inflation and output (or
negative relationship between inflation and unemployment).
However, the figure represents a cross-section, i.e., a comparison of

two distinct economies, each with a different fixed inflation rate.
The figure is consistent with the evidence in Lucas (1973), who finds
a negative correlation between inflation and output across countries.

Compare Output as a function of Fixed Z
2 a
negative correlation between

total
inflation output across labour
economies with different supply
constant Z's
equivalent
to aggregate
output
The Phillips curve is a time-series comparison of inflation and

unemployment across different periods of the same economy.
To see whether our model is consistent with the Phillips curve we

must introduce variation in the inflation rate over time.

3. Random monetary policy
in the Lucas Model

Random Monetary Policy
Consider our single two-island economy again.
Now monetary policy is random, i.e., Mt =

I Mt−1 with probability θ (zt = 1)
I 2Mt−1 with probability (1 − θ) (zt = 2)
The realization of monetary policy (realized value of zt ) is kept secret

from the young until all transactions take place (they learn Mt when
period t is over).
In order to determine how much to work `, the young would like to
know whether they live on an island with many young people 23 N or
few young people 31 N .
The young can only directly observe prices on their island pti .

Confusion over source of price change
Can they still infer the population of young on their island by looking
at the price? (as they were able to do when z was non-random)
Consider the market clearing condition N i ` pti = vti M2t , which

implies,
Mt /2 z (Mt−1 /2)
pti = i i
= t
N i ` pti

N ` pt
... but now since both N i and zt are unknown to the individual
(random variables), they can no longer always infer N i by just looking
at pti .
For example, a high price of goods pti may result from:

I a low population of young workers, N i = 31 N
I or a high stock of fiat money, zt = 2

Source of price change matters
Whether it is one or the other is important for the young.

I if the high pti comes from small N i , all the young will want to work
hard because it means strong demand for their product and therefore a
good anticipated average return to their labour.
I if high pti comes from an increase in Mt there is no reason to work
especially hard.
A high current money stock Mt does not affect the anticipated rates
of return to money (and labour) because it does not affect
expectations of the future rate of money printing MMt+1
t
= zt+1 .
I Reason: the monetary shocks are independent over time (serially
uncorrelated).

Possible prices
Can the young learn anything about N i from pti ?
In our simple model with two possible population sizes ( 31 N or 23 N)
and two possible rates of money printing (1 or 2), there are four
possible states of the world represented by the various combinations
of N i , zt .

What is the price level in each case? There are 4 possible prices when
the money stock is also random.
Note that for given `,
pta < ptb = ptc < ptd
Therefore, 2 of the 4 possible prices are unique. They can occur in
only one state of the world (particular combination of events):
I pta can occur only when the money stock is small (zt = 1) and the
population is large (N i = 32 N)
I ptd can occur only when the money stock is large (zt = 2) and the
population is low (N i = 31 N)
i i
i
Ze 2 FN 2
g
N 2
ZIT IN EN
FIFI
zezH I e
PE
Outcomes when you can infer the state
So if the young observe ptd they can infer that the population of
young on their island must be small → implies on average they can
expect a good return to work → encourages them to work hard
supplying `dt units of labour.
I Note: ptd is observed only when the stock of fiat money is large, zt = 2.
If the young observe pta they can infer that the population of young
on their island must be large → implies on average they can expect a
poor return to work → encourages them to work little supplying àt
units of labour.
I Note: pta is observed only when the stock of fiat money is low, zt = 1.

Outcomes when you cannot infer the state
What happens in cases b and c?
In these two cases the young are unable to infer the number of young
on their island N i .
The cannot tell if they are on an island with a small number of young
and a small money stock (case b) or on an island with a large number
of young and a large stock of fiat (case c).
Unable to infer anything about N i on their island they “split the

difference,” i.e., each young worker in this situation will produce `∗ -
which is less that they would if they knew the population to be small
(case b), but more than if they knew the population to large (case c).
This will result in an intermediate price level p ∗ which is higher than

p a and lower than p d .
Effects on aggregate output
This randomized monetary policy does not always increase output.
Although in case c people produce more that they would have, had
they known their actual situation ...
... in case b they produce less.
Reason: they think the price they see may signal an increase in the
money stock instead of an increase in the demand for their product.
In an economy there is always one island with a large population of

young and another with a small population of young.

Effects on aggregate output
Therefore, in periods when zt = 2, one island will be at c and the

other at d, and total output will be a weighted average of `c and `d ,
2 1
Aggregate Outputzt =2 = N`∗ + N`d
3 3
In periods when zt = 1, one island will be at a and the other at b,

and total output will be a weighted average of à and `b ,
2 1
Aggregate Outputzt =1 = N`d + N`∗
3 3
This results in a relationship similar to the Phillips curve: output is

high when the inflation rate is high (high zt ).

5. Lucas Critique

Non-random Monetary Policy
Suppose the government raises the stock of fiat money (inflates) and
this is expected by all individuals in the economy, i.e., it is observed
→ aggregate output will fall.
In this case individuals know that the relative prices across islands
reflet relative demand.
The higher expected z reduces the anticipated real rate of return to

work,
j i N j ` pj
vt+1 p t+1 1
i
= jt =
N ` pti z

vt i
pt+1
This reduces individual labour supply on both islands, and thus
reduces aggregate output.

Suppose the government unexpectedly increases the money stock

(inflates), i.e., it is not observed by individuals → aggregate output
will increase.
The reason is that individuals are confused: individuals on the island

with many young people and high inflation ( 23 N, 2), i.e., in state c,
are unsure of the source of the price increase → they think they may
be on the island with the low population of young and low inflation
( 13 N, 1), i.e., state b → they increase their output somewhat (whereas
had they known their true situation they wouldn’t).
Thus, the unexpected increase in the money stock leads to higher

prices (inflation) and higher output → positive association between
inflation and output.

If we would look at an economy over a long period of time we would

see that in periods in which M is high, output is high.
Then we would be tempted to infer that the government can increase

output by simply printing more money.
This policy would not work: although there is a statistical relationship

between inflation and output there is no exploitable trade-off.
If policy-makers tried to exploit this trade-off by increasing the growth

rate of the money supply permanently every period in order to always
increase output they would not increase output but in fact reduce it.

Change in policy regime
To see this, suppose that the government decided to unexpectedly

increase the growth rate of the money stock, what would happen?
Initially, as this change is unknown to the public, output will increase.
As individuals figure out (they are rational) that z has increased it

becomes expected → switch from unexpected to expected regime →
individuals are no longer confused → output falls.
If the increase in z was known from the beginning then output would
fall immediately and there would not even be a brief interval of high
output.

as
FL
time
to ti
time over which

individual confused
o.gg
9afe
7
time
to
Why does this happen?
Because the positive correlation between inflation and output we see

in the data (statistical relationship) is a reduced form correlation
based on historical data, i.e., a correlation between variables that is
the result of the equilibrium reactions of individuals in the economy to
the environment they face (a big part of which is policy)
Lucas Critique (1976): these reduced form correlations are subject to

change when the government policies change because these policies
change the rules under which individuals operate.
When monetary policy is unknown, the best individuals can do is to

“split the difference.”
When monetary policy changes from random to non-random the best

individuals can do is to reduce output.

Implications
It is naive to try to predict the effects of policy based on historical

data relationships.
So to evaluate policies we need an understanding about how

individuals will respond to the new policy, i.e., we need a theory, a
model → microfoundations.
If we understand people’s preferences and constraints, we can predict

how they will react to changes in policy → when the policy regime
changes people behave differently rightarrow expectations about
policy matter.
Criticism of large-scale macro-econometric models.
Other example: investment tax revenue and investment in time-series.

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Monetary Economics II: Theory and Policy

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 1 / 38

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 2 / 38

Standard OLG model of money.

Assumption: individuals live in two spatially separated island (distinct

Total population N across the two islands is constant over time.

The old are randomly distributed across the two islands,

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 3 / 38

The nominal stock of fiat money balances is known with a delay of

No communication between islands is possible within a period (you

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 5 / 38

Individuals make the best possible inference given the information

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 6 / 38

When young people are endowed with y units of time.

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 7 / 38

Let `it = ` pti represent the choice of labour by an individual born in

period t, for a given price of goods pti on island i.

Technology for producing goods:

Note: the amount of labour supplied by an individual depends on the

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 8 / 38

Individual budget constraint when young in period t on island i,

where superscript i denotes island on which individual is born.

Labour is paid in money, mti = `it pti

vti mti = a young individual’s holdings of fiat money in terms of the

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 9 / 38

Money holdings and lump-sum government transfers serve to finance

Budget constraint of an old person on island j in period t + 1,

Second period consumption depends on island i where the individual

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 10 / 38

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 12 / 38

Money stock grows at a fixed rate zt = z in all periods (anticipated

Individuals can determine the current money stock Mt by multiplying

N i ` pti = total demand for fiat money on island i (since N i young)

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 13 / 38

vti M2t = total real supply of fiat money in period t on island i.

Market clearing condition for fiat money in terms of goods,

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 14 / 38

Note, that depending on whether island i has a small or large number

Because the population of the young on each island is the only

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 16 / 38

since the SE dominates the IE we have

multiply both sides by IN

but since Ig L we have

the last two inequalities imply

multiply both sides by Mtz

but this contradicts our

original assumption that

The price of goods is driven by the scarcity of young people producing

Low population of young 13 N → few young producing for the old →

Similarly when the population of young is high, the current price is

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 17 / 38

Of course, because there is always one island with 32 N young and

Prices here do the job we expect them to do in market economies:

ECON3440C - Adamopoulos Monetary Economics, Lecture 7 2021 18 / 38

Real rate of return to work,

A permanent increase in the money stock raises both Mt and Mt+1

A high current price caused by a permanent increase in the money

What is the effect of anticipated inflation z on work? Is money

With Mt+1 = zMt as ↑ z we have ↓ MMt+1 t