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Review Article

by Jorge Rojas October 19th, 2010

The Inflation Tax in a Real Business Cycle Model. By Thomas F. Cooley and Gary D. Hansen, (The American Economic Review , LXXIX (1989), pg. 733)

1. Introduction
The article written by Cooley and Hansen (C&H) attempts to answer three major questions in modern economics. They attempt to see whether money and its supply rule impact on the nature and amplitude of the business cycle. Next, they evaluate the welfare costs related to alternative constrained periods and a constant growth rate for the money supply. Finally, they study the way in which anticipated inflation could affect the value of real macroeconomic variables in the long-run such as consumption, output, investment, labour and capital stock. To do this research, the authors build a real business cycle model that takes into account the role of money. The way in which money is incorporated into the model is basically using a cash-in-advance constraint (or Clower constraint) that applies only to consumption. In other words, this is a condition that establishes that each consumer or firm must have sufficient cash available before they can purchase goods. In addition, there are two ways to supply money: a constant growth rate and in a erratic but correlated way. The model assumes that there is a representative household for the whole economy, and distinguishes among cash goods (consumption) and credit goods (leisure). According to the definitions given by Lucas and Stokey1 (1983), a cash good has to be bought with a formal order of currency previously stored, while a credit good can be purchased with labour income contemporaneously accumulated. In addition, there is only one good that is produced and consumed by the agents in the economy. Overall, the paper is very well-structured and follows the classical tradition in economic models. However, there are important elements that are omitted in order to simplify the mathematics.

2. The Model
The utility function has the constant-relative-risk-aversion form with CRRA coefficient equal to one. The function only considers consumption and leisure at time t.

U = E0

β t (log ct + A log lt)


1. Lucas, Robert E., Jr. and Stokey, Nancy L., “Optimal Fiscal and Monetary Policy in an Economy Without Capital,” Journal of Monetary Economics, XII (July 1983), 491-514.


where β ∈ (0, 1) is the discount factor. Households have an endowment of one unit of time each period and supply labour to the firms in the economy. Furthermore, the agents accumulate capital and they rent it to the firms. An interesting characteristics of this model is that the households enter at period t with nominal money balances equal to mt−1 from the previous period. Notice that consumption is independent of employment, and this holds in equilibrium according to proof provide by Hansen (1985). There are two money supply rules. The first one follows a constant gross growth rate of money, gt, and is given by equation (2), while the second one follows an autoregressive process in its growth rate depicted by equation (3). Mt = gt Mt−1 log gt+1 = α log gt + εt (2) (3)

2 where εt ∼ iid (log(g ) (1 − α), σε and log(g ) is the unconditional mean of the logarithm of ¯ ¯ gt, and Mt is the per capita money supply in period t.

The household’s consumption choice has to satisfy the following constraint: pt ct mt−1 + (gt − 1) Mt−1 (4)

pt is the price level, ct is consumption per household, all at time t. In the paper written by C&H, this constraint is binding under the argument that the gross growth rate of money always exceeds the discount factor β and this is observed in the actual money supply. However, they recognize that if this assumption is not made, then the solution procedure will be more complicated and there might be corner solutions. Usually, what is looked for in economics are the interior solutions because these are nontrivial. Another important assumption is that labour is indivisible. That is, households supply a given positive number of hours (h) as labour, or they do not supply anything at all. This assumption implies that the economy is non-convex, but as Rogerson (1988) did, they convexify the set using employment lotteries that the agents trade. The concept of a convex economy can be better understood as a consumption set A that is convex. This set A is defined following the approach in Rogerson, where kt is capital stock per household: A = {(c, h, k) ∈ R3: c 0, h ∈ B , 0 k 1}2 (5)

Given that in this economy, labour is a discrete set B with only two choices, namely, supply a certain level or nothing at all. This introduces non-convexity in the above set. This assumption could have been valid in the 1980, but in my opinion, that reality has changed over the past decade with the use of Information Technology in many fields which has contributed to the advance of part-time jobs.
2. Rogerson, Richard, “Indivisible Labor, Lotteries and Equilibrium,” Journal of Monetary Economics, XXI (January 1988), 3-16.


Therefore, in their model the household chooses consumption (ct), investment (xt) and the nominal money holdings (mt). This gives the following budget constraint: ct + x t + mt pt wt ht + rt kt + (mt−1 + (gt − 1) Mt−1) pt (6)

where wt is the wage rate, rt is the rental rate of capital and xt is the investment, all at time t. The law of motion for capital has the form given by equation (7): kt+1 = (1 − δ) kt + xt , δ is the depreciation rate. The production function is given by: Yt = exp(zt) Ktθ Ht1−θ , θ ∈ (0, 1) (8) δ ∈ [0, 1] (7)

zt is an exogenous shock to technology that follows an AR(1). In addition, they assume ∂Y ∂Y that markets are competitive, which implies that ∂Kt = rt and ∂Ht = wt.
t t

The representative household wants to maximise their value function, which in equilibrium is as follows:
V (zt , gt , mt , Kt , kt) = max {U (c, h) + β E[V (zt+1, gt+1, mt+1, Kt+1, kt+1|zt , gt , mt , Kt , kt) ˆ ˆ ˆ (9)

This function is subject to the previous constraints. For more details on this, a suggested reading is Morimoto (2010) pages 13 to 16, and Lucas (1987) section II. This function satisfies the Bellman’s equation, a well developed topic in dynamic programming3. Due to the inefficiency induced by money, the second welfare theorem4 cannot be applied, and the solution has to be found directly. After solving the equation with somewhat advanced mathematical tools they found the functions using a quadratic approximation in a neighbourhood of the steady state for the deterministic problem.

3. Results
The following discussion is related to the results of the paper. First of all, the paper partially achieves its goal of answering the questions proposed at the beginning, at least to some extent according to the model described above.
3. Morimoto, Hiroaki, Stochastic Control and Mathematical Modeling , New York: Cambridge University Press, 2010. 4. Hansen, Gary D., “Indivisible Labor and the Business Cycle,” Journal of Monetary Economics, XVI (November 1985), 309-28.


Cyclical properties
From table 1, taken from C&H, can be seen that when the money supply grows at a constant rate, even if it implies a high average inflation rate, the characteristics of the business cycles are not affected. This behaviour is very close to that observed in models without money. On the other hand, when money supply is erratic (in a similar way during the period of the postwar, WWII) its effect is small but significant on the cyclical properties of the economy. Namely, the effect of the volatility of the money supply impacts on the standard deviation of consumption and prices, and in their correlation with output. In other words, consumption and prices become more volatile and less correlated with output.

Figure 1. Cooley and Hansen (1989)

Welfare costs of the inflation tax
The paper analyses the welfare costs comparing steady-states for an economy with a money supply that grows at a constant rate, and in which the cash-in-advance constraint is binding. C&H do not analyse the case with erratic money supply because the Business Cycle has different properties. The former case is chosen by the authors because the characteristics of the business cycles of such an economy are unaffected, and thus they may compare for different levels of inflation. The way in which welfare is measured is expressed in terms of the ratio of the change in consumption to the steady-state real output ∆C/Y , and the steady-state real consumption ∆C/C. Notice that ∆C is based on a measure of the increase in the amount of consumption such that the representative agent will require to be as well off as under the Pareto optimal allocation. There are two assumptions related to the period of time that the individuals are constrained to hold money, quarterly

and monthly. From table 2 in the original article may be seen that if the constrained is monthly, then the welfare costs are importantly diminished.

Figure 2. Cooley and Hansen (1989)

Furthermore, these results are consistent with Fischer (1981) and Lucas (1987), even though the assumptions in this case are different. Fischer and Lucas assume that output is constant and vary the velocity of money, while in this paper the assumption is that velocity is constant and output is allowed to change. Since aggregate money is made up by deposits, that may be protected against the inflation tax through competitive interest rates, and there are also currency and reserves that are subject to the effect of the inflation tax. So, the authors claim that the monthly constraint provide a lower bound to the welfare loss.

Steady-State Implications of Inflation
If the growth rate of the money supply g is greater than the discount factor β (the optimal level for g), then the individuals in this economy will substitute leisure for consumption. Recall that leisure is a credit good and consumption is a cash good. Therefore, if there is inflation, the agents will prefer to have less consumption to pay less of this inflation tax, while prefering more leisure. As a result of the increase in leisure, there is a decrease in labour, and hence a decrease in output. This leads to a decrease in consumption, investment and capital. Notice that the share of output to investment remains unchanged because investment will provide future consumption that will be subject to the same inflation tax as the present. A somewhat surprising and interesting result obtained using this model is that higher inflation rates are associated with lower employment rates. This is completely different to the result obtained by A.W. Phillips (1958). However, the new result is supported with empirical evidence by the authors themselves and also by Milton Friedman (1977).

Figure 3. Cooley and Hansen (1989)

Figure 4. Milton Friedman (1977)

Figure 5. A.W. Phillips (1958)

4. General critique and Conclusions
The main contribution of the article is that the effects of money are taken into account in a real business cycle model, through the use of a cash-in-advance constraint and money supply forms. The results of this model are consistent with previous literature and explain some striking outcomes such as the positive relationship between inflation rate and unemployment rate, in constrant with the Phillips curve.

However, there are a number of simplifying assumptions that diminish the power of the model. • There is only one representative agent5. This does not take into account different amount of skills or income distribution in the individuals of the economy. There is production of only one good that is consumed, traded and produced. In reality, there are many different goods and substituion effects between them that have an impact on the economy. Unexpected inflation has no role in the model. This is explicitely recognized by the authors. The economy is competitive, but in reality there are many examples in which firms have an important market power. As a result, the firms do not act as price takers. The cash-in-advance constraint is always binding in the analysis to simplify the math involved. Nevertheless, this could not be always the case. Labour is assumed to be indivisible, but there are many cases in which agents provide different amounts of labour (part-time jobs). Consumption is independent of the labour income earns in a period of time. This is clearly not the case in actual economies. According to consumer theory, people tend to consume more when their income is higher and less when their income is lower (budget constraints). The empirical evidence to support the positive relationship between inflation rate and unemployment rate does not have a detailed explanation in the choice of the countries. In econometrics, researchers are very careful about data since different sets of data may lead to different conclusions.

Therefore, a way to improve the model is to relax any of the aforementioned assumptions, and enrich the econometrics deployed.

5. For more details about having different representative agents the following is a good book to read: Salvadori, Neri, Economic Growth and Distribution: On the Nature and Causes of the Wealth of Nations , Chapter 4.


[1] Fischer, Stanley, “Towards an Understanding of The Costs of Inflation,” CarnegieRochester Conference on Public Policy, K. Brunner and A. Meltzer, eds. Autumn, XV (1981), 5-42. [2] Friedman, Milton, “Nobel Lecture: Inflation and Unemployment,” Journal of Political Economy, LXXXV (June 1977), 451-72. [3] Hansen, Gary D., “Indivisible Labor and the Business Cycle,” Journal of Monetary Economics, XVI (November 1985), 309-28. [4] Lucas, Robert E., Jr., Models of Business Cycle, New York: Basil Blackwell, 1987. [5] Lucas, Robert E., Jr. and Stokey, Nancy L., “Optimal Fiscal and Monetary Policy in an Economy Without Capital,” Journal of Monetary Economics, XII (July 1983), 491-514. [6] Lucas, Robert E., Jr. and Stokey, Nancy L., “Money and Interest in a Cash-in-Advance Economy,” Econometrica, LV (May 1987), 491-514. [7] Morimoto, Hiroaki, Stochastic Control and Mathematical Modeling, New York: Cambridge University Press, 2010. [8] Phillips, A.W., “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957,” Economica, XXV (November 1958), 283-99. [9] Rogerson, Richard, “Indivisible Labor, Lotteries and Equilibrium,” Journal of Monetary Economics, XXI (January 1988), 3-16. [10] Salvadori, Neri, Economic Growth and Distribution: On the Nature and Causes of the Wealth of Nations, Chapter 4 (Cheltenham, UK: Edward Elgar Publishing, Inc., 2006).