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MONETARY ECONOMICS.

Theory and Policy.
Professor: Mikel Casares
Departamento de Economía,
Universidad Pública de Navarra
October 8, 2007
Abstract
The object of these lectures is to provide a short course on monetary economics and essential
portions of macroeconomics. The course is intended for advanced students but presented
in a manner that emphasizes economic substance rather than mathematical technique. We
will begin with three chapters devoted to analyze the role of money in modern economies by
using a general equilibrium deterministic framework. Four models will be presented: money
in the utility function model, cash-in-advance model, shopping time model, and transaction
costs model. All of them have in common the medium of exchange role for the asset to be
regarded as money. A money demand function will be derived in each of them in order to
determine the motivations to hold money. The superneutrality property, the Chicago rule
on optimal in‡ation, and the welfare cost of in‡ation will be then discussed.
In the second part of the course we will learn how to solve rational expectation models in
order to obtain the Minimal State Variable solution. These techniques will allow us to solve
the dynamic models in the short run in the presence of uncertainty. As one initial example,
an IS-LM type model of the aggregate demand with constant prices will be solved. Then, we
will lift the constant price assumption by introducing ‡exible prices and some price setting
behavior. In turn, the aggregate supply equation of the model will be obtained to complete
the model.
In the last part of the course, attention will focus on business cycle and monetary pol-
icy analysis. Monetary policy rules will be examined taking either the targeting rules or
instrument rules approach. Taylor type monetary policy rules will be studied in detail as a
representative example of instrument rules on the nominal interest rate.
PART 1. Long-run analysis.
Reading list:
Casares, Miguel (2000), ”Long-run and short-run issues in optimizing monetary models”.
Doctoral thesis. Chapter 1, pages 5-61.
McCallum, Bennett T., (1989). ”Monetary Economics. Theory and Policy”. Macmillan
Publishing Company Eds. New York, USA. Chapter 2, pages 16-32.
McCallum, Bennett T., (1999). ”A Course in Macro and Monetary Economics”. Lecture
Notes. GSIA, Carnegie Mellon University. Chapter 1, pages 1-12.
Walsh, Carl E., (2003). ”Monetary Theory and Policy”, 2nd Edition. MIT Press Eds.
Cambridge, MA. Chapters 2 and 3, pages 43-134.
1 A General-Equilibrium Framework with Money
1.1 Introduction
De…nition of money.
The starting point of any Monetary Economics course should be some discussion on the
nature and de…nition of money. Our de…nition of money will be M1 which roughly speaking
comprises two components: currency in circulation and checking accounts. Broader de…n-
itions of money like M2 or M3 would also incorporate savings deposits or money market
(short-term) assets. However we will not consider them in this course for reasons men-
tioned below. According to the M1 de…nition, the stock of money of one economy has two
characteristics:
1) Perfect liquidity. Money is an asset that can be used by every consumer to buy every
good without any charge.
2) Zero nominal yield. Money is an asset that pays no nominal interest rate. Its real
rate of return will be given by the rate of in‡ation. If prices go up (positive in‡ation) the
purchasing power of money will fall so as to have a negative real rate of return. Likewise, a
positive rate of return could be obtained if prices went down and more goods and services
could be purchased with the same amount of money.
Functions of money.
It is said that there are three functions of money:
1
1) Medium of exchange. Money facilitates transactions as it is accepted by everybody
in the exchange. This function is based on the ”perfect liquidity” characteristic mentioned
above. Obviously, the medium of exchange role of money has a tremendous impact on the
volume of purchases and sales in the economy. Think for a moment of two economies with
the same resources but one with money and one without money (barter economy). What
would happen in the non-monetary economy ? Problems such as the double coincidence of
wants and non-divisible goods would arise making the exchanges very costly. Transaction
costs would be much higher in this economy without money.
2) Medium of account. Another important function provided by money is serving as a
medium of account that gives prices to all the distinct goods of the economy. This function of
money also reduces substantially the transaction costs. In particular, the information costs
are much lower in a monetary economy. The introduction of money allows us to express the
value of all goods (their price) in terms of the units of money. In an economy with N goods,
there would be N-1 prices to learn. If this economy were a barter economy shoppers would
have N(N-1)/2 relative prices to learn. As one illustrative example, I suggest you calculate
the number of prices to memorize when there are 1000 goods in the economy (N=1000).
3) Store of value. Income can be saved for the future in the form of money. As money
does not deteriorate over time (at least over quite a long period of time!), it can be used to
store value. In modern economies the store-of-value property is also found in other assets
such as bonds, shares or real state properties. Since money pays no interest, it is considered
inferior to any of the other store-of-value assets: bonds pay an interest yield, shares pay
dividends and real state pay a rental rate. This inferiority is increased when money is falling
in value because of a positive rate of in‡ation. From a purely rational perspective, our
savings should be placed in some risk-free interest-bearing asset and money demand for this
purpose should be zero.
During this course the role of money as a medium of exchange will be emphasized so
as to be the …nal motivation to demand money. The reason is as follows: the medium
of exchange function of money is the only one that distinguishes money from any other
asset because the medium-of-account role could conceivably fall to some other commodity
whereas there are many nonmonetary assets that serve as stores of value. Subsequently, our
de…nition of money should only include purely medium-of exchange assets like M1. Other
more inclusive de…nitions (M2, M3), which will not be considered here, include some interest-
bearing components that loose the full liquidity property and gain motivation to demand
money as a store of value.
2
Our models will be built from optimizing behavior of economic agents. In particular,
a discrete-time version of the neoclassical model developed by Sidrauski (1967) and Brock
(1975) will be taken here. In this framework, the economy is formed by in…nitely-lived
households who are also producers and maximize their intertemporal utility subject to a
sequence of constraints.
The nature of money will be analyzed in four di¤erent models that incorporate, more
or less explicitly, the medium-of-exchange function of money: money in the utility function
model (MIU), cash-in-advance model (CIA), transactions technology model, and shopping
time model. In this …rst part of the course attention will focus on long-run analysis. The
e¤ects of money and monetary policy in the long run will be explored in a deterministic
framework. As stochastic elements have no in‡uence in the steady state, the models will be
studied in a perfect foresight scenario.
1.2 Money in the utility function model (MIU)
In the money in the utility function model (MIU), the arguments of the utility function
are consumption units c, leisure time |, and real money balances : =
A
1
being ` nominal
money and 1 the price level. Thus, the representative household of the economy wants at
time t to maximize
l(c
t
. :
t
. |
t
) + ,l(c
t+1
. :
t+1
. |
t+1
) + ,
2
l(c
t+2
. :
t+2
. |
t+2
) + ....
where , =
1
1+j
and j 0 is the intertemporal rate of discount. Households are also producers
and obtain their output ¸
t
by employing the demand for labor :
o
t
and the stock of capital /
t
within the existing production technology
¸
t
= ,(:
o
t
. /
t
).
Both the utility function and the production function are well-behaved functional forms in
the sense that they have positive …rst-order derivatives, negative second-order derivatives,
and satisfy the Inada conditions.
The budget constraint faced by the household in period t is in nominal terms
1
t
,(:
o
t
. /
t
)+G
t
= 1
t
c
t
+1
t
(/
t+1
(1 o)/
t
)+\
t
(:
o
t
:
c
t
)+(1+1
t
)
1
1
t+1
1
t
+`
t
`
t1
.
There are two sources of income: 1
t
,(:
o
t
. /
t
) is the nominal output produced in period t, and
G
t
is the government net transfers to the household. Income is spent on consumption 1
t
c
t
, on
3
capital accumulation for next period’s production net of capital depreciation /
t+1
(1o)/
t
,
being o the rate of depreciation of capital, on nominal wage spending for the labor demand net
of labor supply \
t
(:
o
t
:
c
t
), on increasing government bonds balances (1+1
t
)
1
1
t+1
1
t
, and
on increasing money balances for the current period `
t
`
t1
. Regarding the government
bonds purchases, (1 +1
t
)
1
1
t+1
is the amount bought in period t by the household so that
it produces a reimbursement equal to 1
t+1
in period t + 1. Thus, 1
t
is the nominal interest
rate over period t.
If we divide the previous expression by the price level, the household budget constraint
in real terms becomes
,(:
o
t
. /
t
) + q
t
= c
t
+ /
t+1
(1 o)/
t
+ n
t
(:
o
t
:
c
t
) + (1 + 1
t
)
1
1
t+1
1
t
/
t
+ :
t

`
t1
1
t
.
where lower case variables denote the real-term value of the capital case variable.
Let us de…ne :
t
as the rate of in‡ation in period t
:
t
=
1
t
1
t1
1.
and :
t
as the real rate of interest in period t from
1 + :
t
=
1 + 1
t
1 + :
t+1
Back to the household budget constraint, dividing and multiplying
1
t+1
1t
by 1
t+1
and
A
t1
1t
by
1
t1
, and using both the in‡ation and the real interest rate de…nitions result in
,(:
o
t
. /
t
) +q
t
= c
t
+/
t+1
(1 o)/
t
+n
t
(:
o
t
:
c
t
) +(1 +:
t
)
1
/
t+1
/
t
+:
t
(1 +:
t
)
1
:
t1
.
As for the time constraint, households divide their total time 1 between labor supply and
leisure time
1 = :
c
t
+ |
t
.
Taking the previous lines into consideration, the optimizing program to solve in the MIU
model is
`cr
ct,I
t+1
,a
d
t
,a
s
t
,|t,b
t+1
,nt
l(c
t
. :
t
. |
t
) + ,l(c
t+1
. :
t+1
. |
t+1
) + ,
2
l(c
t+2
. :
t+2
. |
t+2
)......
subject to
,(:
o
t+)
. /
t+)
) + q
t+)
c
t+)
/
t+1+)
+ (1 o)/
t+)
n
t+)
(:
o
t+)
:
c
t+)
)
(1 + :
t+)
)
1
/
t+1+)
+ /
t+)
:
t+)
+ (1 + :
t+)
)
1
:
t1+)
= 0. , = 0. 1. 2. ...
4
1 :
c
t+)
|
t+)
= 0. , = 0. 1. 2. ...
Let us recall that …rst order conditions are obtained by taking partial derivatives of the
Lagrangian function with respect to all the choice variables and the Lagrange multipliers,
and making them equal to zero. The Lagrangian function of the optimizing program at hand
is
1
t
= l(c
t
. :
t
. |
t
) + ,l(c
t+1
. :
t+1
. |
t+1
) + ,
2
l(c
t+2
. :
t+2
. |
t+2
) + ...
+`
t
_
,(:
o
t
. /
t
) + q
t
c
t
/
t+1
+ (1 o)/
t
n
t
(:
o
t
:
c
t
) (1 + :
t
)
1
/
t+1
+ /
t
:
t
+ (1 + :
t
)
1
:
t1
¸
+,`
t+1
[,(:
o
t+1
. /
t+1
)+q
t+1
c
t+1
/
t+2
+(1o)/
t+1
n
t+1
(:
o
t+1
:
c
t+1
)(1+:
t+1
)
1
/
t+2
+/
t+1
:
t+1
+ (1 + :
t+1
)
1
:
t
] + ... + ,
t
[1 :
c
t
|
t
] + ,,
t+1
_
1 :
c
t+1
|
t+1
¸
+ ....
where `
t
and ,
t
are respectively the Lagrange multipliers of the budget and time constraints
in period t. Thus, the …rst order conditions regarding the choice variables in period t are
1
l
ct
`
t
= 0. (c
)cc
t
)
`
t
+ ,`
t+1
(1 + ,
I
t+1
o) = 0. (/
)cc
t+1
)
`
t
(,
a
d
t
n
t
) = 0. (:
o,)cc
t
)
`
t
n
t
,
t
= 0. (:
c,)cc
t
)
l
|t
,
t
= 0. (|
)cc
t
)
`
t
(1 + :
t
)
1
+ ,`
t+1
= 0. (/
)cc
t+1
)
l
nt
`
t
+ ,`
t+1
(1 + :
t+1
)
1
= 0. (:
)cc
t
)
,(:
o
t
. /
t
) + q
t
c
t
/
t+1
+ (1 o)/
t
n
t
(:
o
t
:
c
t
) (1 + :
t
)
1
/
t+1
+ /
t
:
t
+ (1 + :
t
)
1
:
t1
= 0.
(`
)cc
t
)
1 :
c
t
|
t
= 0. (,
)cc
t
)
A Competitive Equilibrium (CE) in the MIU model
A CE of the economy consists of the nine …rst order conditions, together with the gov-
ernment budget constraint
q
t
= (1 + :
t
)
1
/
t+1
/
t
+ :
t
(1 + :
t
)
1
:
t1
.
1
The partial derivatives take the following notation for a generic 1(r
|
, j
|
) function
1
rt
=
JJ(rt,¸t)
Jrt
and 1
¸t
=
JJ(rt,¸t)
J¸t
5
the labor market equilibrium condition
:
o
t
= :
c
t
.
the production technology
¸
t
= ,(:
o
t
. /
t
).
and de…nitions of the rate of in‡ation :
t
=
1t
1
t1
1, the real interest rate 1+:
t
=
1+1t
1+¬
t+1
, and
real money balances :
t
=
At
1t
.
2
In turn, there are …fteen equations in the CE system. Fiscal
and monetary policy determine exogenously paths for q
t
and `
t
. Hence, the …fteen equations
of our CE economy govern the dynamic behavior of the …fteen endogenous variables c
t
. /
t+1
.
/
t+1
. :
o
t
. :
c
t
. |
t
, :
t
. ¸
t
, `
t
, ,
t
, n
t
, 1
t
, :
t
, 1
t
, and :
t
provided the predetermined values /
t
, /
t
.
:
t1
, and 1
t1
.
Obtaining the Structural Equations
Substituting ,`
t+1
= `
t
(1 + :
t
)
1
from (/
)cc
t+1
) into (/
)cc
t+1
) and simplifying lead to the
capital accumulation equation
,
I
t+1
o = :
t
.
The optimal stock of capital left for the next period is the one whose marginal productivity
minus the depreciation rate is equal to the real interest rate. This is the arbitrage condition
between the return on the physical asset (capital) and the real return on the …nancial asset
(bonds).
Taking the values of the Lagrange multipliers `
t
and `
t+1
respectively from (c
)cc
t
) and the
corresponding (c
)cc
t+1
) to the bonds …rst order condition will bring about the intertemporal
consumption equation
l
ct
,l
c
t+1
= 1 + :
t
.
Marginal utility of consumption in period t relative to discounted marginal utility of con-
sumption in period t + 1 is equal to their relative price.
Finally the money demand equation can be obtained by inserting ,`
t+1
= `
t
(1 + :
t
)
1
from (/
)cc
t+1
) into (:
)cc
t
), rearranging and using the nominal interest rate de…nition
l
nt
l
ct
=
1t
1+1t
.
2
Since money supply is determined exogenously the real money balances de…nition :
|
=
1t
1t
can also be
viewed as the money market equilibrium condition.
6
Now the ratio of marginal utilities is equal to their relative income price. Notice that the
price of real money balances is the discounted nominal interest rate
1t
1+1t
, which re‡ects that
the opportunity cost of holding real money balances takes into account both the real interest
rate and next period’s rate of in‡ation.
1.3 Cash-in-advance model (CIA)
Here we have another view of the role of money as a medium-of-exchange. Money as some-
thing necessary to conduct any purchase. It is the only counterpart to any transaction.
This is the reason why the cash-in-advance constraint emerges. The household must keep
an amount of money at least equal to the desired consumption expenditures
`
t+)
1
t+)
c
t+)
, = 0. 1. 2. ....
dividing by the price level, it becomes in real terms
:
t+)
c
t+)
, = 0. 1. 2. ...
Money is only demanded to satisfy the cash-in-advance constraint. It does not enter the
utility function which now only depends on consumption and leisure. However, the cash-in-
advance is one more constraint attached to the maximization problem
3
`cr
ct,I
t+1
,a
d
t
,a
s
t
,|t,b
t+1
,nt
l(c
t
. |
t
) + ,l(c
t+1
. |
t+1
) + ,
2
l(c
t+2
. |
t+2
) + ......
subject to
,(:
o
t+)
. /
t+)
) + q
t+)
c
t+)
/
t+1+)
+ (1 o)/
t+)
n
t+)
(:
o
t+)
:
c
t+)
)
(1 + :
t+)
)
1
/
t+1+)
+ /
t+)
:
t+)
+ (1 + :
t+)
)
1
:
t1+)
= 0. , = 0. 1. 2. ...
1 :
c
t+)
|
t+)
= 0. , = 0. 1. 2. ...
:
t+)
c
t+)
= 0 , = 0. 1. 2. ...
3
The cash-in-advance inequality turns to be binding because the nominal interest rate is always greater
than zero.
7
Once built the Lagrangian function, the computation of the …rst order conditions of the
program in period t results in
l
ct
`
t
¸
t
= 0. (c
)cc
t
)
`
t
+ ,`
t+1
(1 + ,
I
t+1
o) = 0. (/
)cc
t+1
)
`
t
(,
a
d
t
n
t
) = 0. (:
o,)cc
t
)
`
t
n
t
,
t
= 0. (:
c,)cc
t
)
l
|t
,
t
= 0. (|
)cc
t
)
`
t
(1 + :
t
)
1
+ ,`
t+1
= 0. (/
)cc
t+1
)
`
t
+ ,`
t+1
(1 + :
t+1
)
1
+ ¸
t
= 0. (:
)cc
t
)
,(:
o
t
. /
t
) + q
t
c
t
/
t+1
+ (1 o)/
t
n
t
(:
o
t
:
c
t
) (1 + :
t
)
1
/
t+1
+ /
t
:
t
+ (1 + :
t
)
1
:
t1
= 0.
(`
)cc
t
)
1 :
c
t
|
t
= 0. (,
)cc
t
)
:
t
c
t
= 0. (¸
)cc
t
)
where `
t
, ,
t
, and ¸
t
are respectively the Lagrange multipliers attached to the budget, time,
and cash-in-advance constraints in period t.
A Competitive Equilibrium (CE) in the CIA model
A CE of the economy consists of the ten …rst order conditions, together with the govern-
ment budget constraint
q
t
= (1 + :
t
)
1
/
t+1
/
t
+ :
t
(1 + :
t
)
1
:
t1
.
the labor market equilibrium condition
:
o
t
= :
c
t
.
the production technology
¸
t
= ,(:
o
t
. /
t
).
and de…nitions of the rate of in‡ation :
t
=
1t
1
t1
1, the real interest rate 1+:
t
=
1+1t
1+¬
t+1
, and
real money balances :
t
=
At
1t
. In turn, there are sixteen equations in the CE system. Fiscal
and monetary policy determine exogenously paths for q
t
and `
t
. Hence, the sixteen equa-
tions of our CE economy govern the dynamic behavior of the sixteen endogenous variables
c
t
. /
t+1
. /
t+1
. :
o
t
. :
c
t
. |
t
, :
t
. ¸
t
, `
t
, ,
t
, ¸
t
. n
t
, 1
t
, :
t
, 1
t
, and :
t
provided the predetermined
values /
t
, /
t
. :
t1
, and 1
t1
.
8
1.4 Transaction costs model
The transaction costs approach assesses that some output resources of the household are
employed in paying transaction costs when carrying out transactions. To reach the desired
level of consumption c
t
, the household must face some costs (transportation, searching costs,
trading costs,...) by using units of output within the available transactions technology.
Thus, transaction costs are expressed in output units whereas in the shopping time model
below they will be given in time units. This creates a new element in the household budget
constraint: a transactions cost function /(c
t
. :
t
). More consumption requires more resources
utilized to pay the transaction costs for the additional purchases. Real money holdings is
the other entry of this function. Since money is the medium of exchange, it provides services
that make transactions easier and decrease the costs associated with shopping. Hence,
the transactions cost function is a¤ected in a positive way by the consumption level and
negatively by the amount of real money
/
t
= /(c
t
. :
t
).
with /
ct
0. /
nt
< 0. /
c
2
t
0. /
n
2
t
0. /
ctnt
< 0 and /(0. :
t
) = 0. The transactions-
facilitating property of money as a medium of exchange is represented through the signs
/
nt
< 0 and /
ctnt
< 0 which imply that the use of more monetary services reduces the total
and marginal transactions costs. Thus, the cross derivative is negative, implying that the
marginal cost of purchasing is lower in the presence of more monetary services to facilitate
transactions. In addition consumption marginal transaction costs are increasing (/
c
2
t
0)
and real money marginal savings of transaction costs are decreasing (/
n
2
t
0).
As the medium-of-exchange function of money is included in the transaction costs func-
tion, real money balances do not appear in the utility function. Household’s utility only
depends on consumption. The optimizing program to solve in the transaction costs model is
`cr
ct,I
t+1
,a
d
t
,a
s
t
,|t,b
t+1
,nt
l(c
t
. |
t
) + ,l(c
t+1
. |
t+1
) + ,
2
l(c
t+2
. |
t+2
) + ...
subject to
,(:
o
t+)
. /
t+)
) + q
t+)
c
t+)
/
t+1+)
+ (1 o)/
t+)
n
t+)
(:
o
t+)
:
c
t+)
)
(1+:
t+)
)
1
/
t+1+)
+/
t+)
:
t+)
+(1+:
t+)
)
1
:
t1+)
/(c
t+)
. :
t+)
) = 0. , = 0. 1. 2. ...
1 :
c
t+)
|
t+)
= 0. , = 0. 1. 2. ...
9
that turns into the following …rst order conditions
l
ct
`
t
(1 + /
ct
) = 0. (c
)cc
t
)
`
t
+ ,`
t+1
(1 + ,
I
t+1
o) = 0. (/
)cc
t+1
)
`
t
(,
a
d
t
n
t
) = 0. (:
o,)cc
t
)
`
t
n
t
,
t
= 0. (:
c,)cc
t
)
l
|t
,
t
= 0. (|
)cc
t
)
`
t
(1 + :
t
)
1
+ ,`
t+1
= 0. (/
)cc
t+1
)
`
t
(1 + /
nt
) + ,`
t+1
(1 + :
t+1
)
1
= 0. (:
)cc
t
)
,(:
o
t
. /
t
) + q
t
c
t
/
t+1
+ (1 o)/
t
n
t
(:
o
t
:
c
t
) (1 + :
t
)
1
/
t+1
+ /
t
:
t
+ (1 + :
t
)
1
:
t1
/
t
= 0.
(`
)cc
t
)
1 :
c
t
|
t
= 0. (,
)cc
t
)
where `
t
and ,
t
represent the Lagrange multipliers associated to the budget and time con-
straints in period t. Note the presence of the transactions technology in (c
)cc
t
), (:
)cc
t
), and
(`
)cc
t
).
1.5 Shopping time model
In a shopping time model, there are transaction costs expressed in units of time and money
appears a¤ecting the transactions time technology. As being the medium of exchange, money
is utilized by the household to economize the time spent on carrying out transactions. With-
out money, the household must negotiate a payment by credit or spend some time on trans-
forming part of its income to money. These alternatives to money suppose a higher amount
of time spent on shopping. Besides, it seems obvious that a greater amount of consumption
will require more shopping time. Thus, we present a generic shopping time function whose
arguments are consumption and real money balances
:
t
= :(c
t
. :
t
)
with :
ct
0. :
nt
< 0. :
c
2
t
0. :
n
2
t
0. :
ctnt
< 0. and :(0. :
t
) = 0, equivalently to the
transactions technology introduced in the transaction costs model. Again, the medium-of-
exchange function of money is represented by the signs :
nt
< 0 and :
ctnt
< 0 which imply
that the use of more monetary services reduces the total and marginal transactions costs.
10
Taking into account the shopping time in the time constraint, households spend their
time on three activities: labor supply (:
c
t
), shopping (:(c
t
. :
t
)) and leisure (|
t
),
1 = :
c
t
+ :(c
t
. :
t
) + |
t
.
Hence, the optimizing program of the shopping time model will be
`cr
ct,I
t+1
,a
d
t
,a
s
t
,|t,b
t+1
,nt
l(c
t
. |
t
) + ,l(c
t+1
. |
t+1
) + ,
2
l(c
t+2
. |
t+2
) + ...
subject to
,(:
o
t+)
. /
t+)
) + q
t+)
c
t+)
/
t+1+)
+ (1 o)/
t+)
n
t+)
(:
o
t+)
:
c
t+)
)
(1 + :
t+)
)
1
/
t+1+)
+ /
t+)
:
t+)
+ (1 + :
t+)
)
1
:
t1+)
= 0. , = 0. 1. 2. ...
1 :
c
t+)
:(c
t+)
. :
t+)
) |
t+)
= 0. , = 0. 1. 2. ...
The …rst order conditions coming up from the optimizing program in period t are
l
ct
`
t
,
t
:
ct
= 0. (c
)cc
t
)
`
t
+ ,`
t+1
(1 + ,
I
t+1
o) = 0. (/
)cc
t+1
)
`
t
(,
a
d
t
n
t
) = 0. (:
o,)cc
t
)
`
t
n
t
,
t
= 0. (:
c,)cc
t
)
l
|t
,
t
= 0. (|
)cc
t
)
`
t
(1 + :
t
)
1
+ ,`
t+1
= 0. (/
)cc
t+1
)
`
t
+ ,`
t+1
(1 + :
t+1
)
1
,
t
:
nt
= 0. (:
)cc
t
)
l
|t
,
t
= 0 (|
)cc
t
)
,(:
o
t
. /
t
) + q
t
c
t
/
t+1
+ (1 o)/
t
n
t
(:
o
t
:
c
t
) (1 + :
t
)
1
/
t+1
+ /
t
:
t
+ (1 + :
t
)
1
:
t1
= 0.
(`
)cc
t
)
1 :
c
t
:(c
t
. :
t
) |
t
(,
)cc
t
)
where `
t
and ,
t
are the Lagrange multipliers associated with the budget and time constraints
respectively. Notice the presence of the shopping technology in (c
)cc
t
), (:
)cc
t
), and (,
)cc
t
).
PROBLEMS.
1.1. Let us assume that the representative household of an MIU economy has a logarith-
mic separable utility function in consumption, leisure, and real money balances l(c
t
. :
t
. |
t
) =
11
log c
t
+ c log |
t
+ / log :
t
with c,/ 0. and a Cobb-Douglas production function ,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with 0 < c < 1.
i) Calculate the capital accumulation, consumption, and money demand equations.
ii) Take logarithms on both sides of the consumption equation, use the approximation
|oq(1 +r
t
)

= r
t
when r
t
is a small number for |oq(1 +:
t
) and solve for log c
t
. Is real money
a¤ecting consumption decisions?
iii) Take logarithms on both sides of the money demand equation and calculate the
elasticities of real money with respect to consumption and the nominal interest rate (take
1t
1+1t
to represent the nominal interest rate).
iv) What would happen to capital, consumption, and real money balances if there were
an increase in /?
1.2. Now the representative household has a non-separable utility function displaying
constant relative risk aversion as in Walsh (1998) page 69
l(c
t
. :
t
. |
t
) =
_
c
t
:
b
t
_

1 c
+
|
1j
t
1 j
nit/ /. j. c. 0, 0 < / (1 c) < 1.
and still a Cobb-Douglas production function ,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with 0 < c < 1.
i) Calculate the capital accumulation, consumption, and money demand equations.
ii) Take logarithms on both sides of the consumption equation, use the approximation
|oq(1 +r
t
)

= r
t
when r
t
is a small number for |oq(1 +:
t
) and solve for log c
t
. Is real money
a¤ecting consumption decisions?
iii) Take logarithms on both sides of the money demand equation and calculate the
elasticities of real money with respect to consumption and the nominal interest rate (take
1t
1+1t
to represent the nominal interest rate).
iv) What would happen to capital, consumption, and real money balances if there were
an increase in /?
1.3. Calculate the capital accumulation, consumption, and money demand equations for
the CIA model described in section 1.3. Regarding the money demand equation, what is the
consumption elasticity? And what is the nominal interest rate elasticity?
1.4. Describe a Competitive Equilibrium (CE) for the transactions technology model of
section 1.4.
1.5. Calculate the capital accumulation, consumption, and money demand equations for
the transactions technology model described in section 1.4.
12
1.6. In a transaction costs model the transactions technology is given by the following
transaction costs function
/(c
t
. :
t
) =
_
¸
_
¸
_
0 i, c
t
= 0
/
0
+ /
1
c
I
2
t
:
I
3
t
i, c
t
0
_
¸
_
¸
_
nit/ /
0
. /
1
. /
3
0 c:d /
2
1.
Assuming a logarithmic utility function in consumption and leisure l(c
t
. |
t
) = log c
t
+c log |
t
with c 0. and a Cobb-Douglas production function ,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with 0 < c < 1,
i) Verify that the transactions technology satisfy /
ct
0. /
nt
< 0. /
ctnt
< 0 and
/(0. :
t
) = 0.
ii) Calculate the money demand equation in logarithmic representation.
iii) Describe how an increase in /
3
would a¤ect the elasticities in the money demand
equation.
1.7. Describe a Competitive Equilibrium (CE) for the shopping time model of section
1.5.
1.8. Obtain the money demand equation for the shopping time model described in section
1.5. Discuss some intuitive interpretation.
1.9. In a shopping time model the transactions technology is given by the following
function
:(c
t
. :
t
) =
_
_
_
0 i, c
t
= 0
:
0
+ :
1
c
c
2
t
:
c
3
t
i, c
t
0
_
_
_
nit/ :
0
. :
1
. :
3
0 c:d :
2
1.
Assuming a logarithmic utility function in consumption and leisure l(c
t
. |
t
) = log c
t
+c log |
t
with c 0. and a Cobb-Douglas production function ,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with 0 < c < 1,
i) Calculate the money demand equation in logarithmic representation.
ii) Describe how an increase in :
3
would a¤ect the elasticities in the money demand
equation.
13
2 Steady State and Superneutrality
The steady state is a situation in which every variable of the model grows at the same constant
rate. Moreover, this constant growth scenario will be maintained forever. In this sense the
steady state is de…ned as a long-run equilibrium situation. In neoclassical models the source
of long-run growth (or steady-state growth) is the growth in the technological process. Since
the technological process happens to be exogenous, the neoclassical growth model is classi…ed
as an Exogenous Growth Model. Any growth rate given to the technological process would
become the steady-state rate of growth of the variables of the economy. Having a positive
growth would just imply that variables were growing at a positive rate over time in steady
state but this would not explain anything about the last determinants of these variables.
Throughout this course we will abstract from positive economic growth because this is not
relevant on the steady state properties of the model.
Thus, our …rst task is to compute the steady state solution of our monetary models. Let
us start by showing four general results.
2.1 General steady-state results
Result 1. Steady state real interest rate.
In every monetary model of chapter 1, the bonds …rst order condition (/
)cc
t+1
) is
`
t
(1 + :
t
)
1
,`
t+1
= 0.
The Lagrange multiplier is constant in steady state because there is no long-run growth in
consumption. If the economy were already in steady state in period t, for the coming period
the Lagrange multiplier would be the same `
t
= `
t+1
and so the real interest rate would.
Simplifying notation by dropping the time subscripts
`(1 + :)
1
,` = 0.
Eliminating ` from the equation and recalling , =
1
1+j
: = j
The real rate of interest is equal to the household’s intertemporal rate of discount.
Result 2. Steady state marginal product of capital.
14
In every monetary model of chapter 1, the capital …rst order condition (/
)cc
t+1
) is
`
t
+ ,`
t+1
(1 + ,
I
t+1
o) = 0.
which in steady state becomes
` + ,`(1 + ,
I
o) = 0.
Eliminating `, and using , =
1
1+j
result in
,
I
= j + o
The marginal product of capital is equal to the household’s intertemporal rate of discount
plus the rate of depreciation of capital. This condition is known as the modi…ed golden rule
in Economic Growth.
Result 3. Steady state real money balances.
The money demand functions obtained from the structural equations of the MIU model
(page 6), the CIA model (exercise 1.3), the transactions technology TT model (exercise 1.5),
and the shopping time TT model (exercise 1.8) are
l
nt
l
ct
=
1
t
1 + 1
t
(MIU)
:
t
= c
t
(CIA)
/
nt
=
1
t
1 + 1
t
(TT)
n
t
:
nt
=
1
t
1 + 1
t
(ST)
The amount of real money balances in steady state will be constant in the four models
because the nominal interest rate, consumption, and the real wage are constant values in the
no growth steady state.
Result 4. Money growth, in‡ation and the nominal interest rate.
From the previous result we have : =
A
1
constant in steady state, which means that
nominal money and prices are growing at the same rate in steady state. The growth rate of
the price level is the de…nition of in‡ation. The money growth rate j =
4A
A
is set by the
central bank exogenously. Therefore, the long-run monetary policy will determine the rate
of in‡ation of the economy
: = j.
15
and the nominal interest rate
1 + 1 = (1 + j) (1 + :) .
with : = j.
2.2 The steady-state solution in the MIU model
The procedure consists of taking the Competitive Equilibriumof the model described in pages
5 and 6 in steady state. Then, after some algebra to eliminate the Lagrange multipliers and
using the general results 1-4, we can reach the following subset of six equations
l
|
l
c
= n.
,
a
= n.
| = 1 :.
¸ = ,(:. /)
¸ = c + o/.
,
I
= j + o.
In principle, the six-equation system would …nd steady-state values for the real sector
variables ¸. :. /. n. c. and |. However, a closer look would bring about the question of
consumption–money separability. The real sector is determined by that six-equation econ-
omy only if real money does not appear in the system. If the quantity held of real money
balances : does a¤ect marginal utility of consumption l
c
. at least another equation –the
money demand equation– should be added to complete the system.
4
In that case, there is no
longer consumption-money separability and the equations representing the monetary sector
of the economy must be attached to the real sector
l
n
l
c
=
1
1 + 1
.
1 + 1 = (1 + j) (1 + :) .
: = j.
in order to obtain steady state values for ¸. :. /. n. c. |,:,1, and :.
4
From an intuitive perspective, the presence of money should be expected because the medium-of-exchange
function of money would yield a positive cross derivative l
cn
0.
16
2.3 Superneutrality in the MIU model
One model is said to have the property of superneutrality when the equilibrium of the real
sector is independent of the rate of growth of nominal money j. The MIU model exhibits
superneutrality if there is consumption-money separability, i.e., if l
cn
= 0.
* Example of a MIU model featuring separability, l
cn
= 0.
There is a MIU economy where households have a separable utility function l(c
t
. :
t
. |
t
) =
log c
t
+ c log |
t
+ / log :
t
with c,/ 0. and a Cobb-Douglas production function ,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with 0 < c < 1. For a quarterly-period calibration, let us assume the values of
the parameters c = 0.36, o = 0.025, j = 0.005, c = 1.828, / = 0.02, 1 = 3, and j = 0.01.
i) Compute the steady state values of ¸. :. /. n. c. and |.
The steady-state real sector system of equation for this economy is
o
|
1
c
= n.
(1 c):
c
/
c
= n.
| = 1 :.
¸ = :
1c
/
c
¸ = c + o/.
c:
1c
/
c1
= j + o.
and inserting the calibration of parameters
1.828c
|
= n.
0.64
_
/
:
_
0.36
= n.
| = 3 :.
¸ = :
_
/
:
_
0.36
¸ = c + 0.025/.
0.36
_
/
:
_
0.64
= 0.03.
Solution: / = 48.553, ¸ = 4.046, c = 2.832, n = 2.589, : = 1, and | = 2. Hint: you
should begin by using the result
I
a
= 48.55 obtained straightforward from the last equation
to calculate easily the real wage.
17
ii) Compute the steady state values of :,1, and :.
The monetary sector is de…ned in steady state by the following equations
0.02
n
1
c
=
1
1 + 1
.
1 + 1 = (1 + 0.005) (1 + :) .
: = 0.01.
where inserting the steady state consumption c = 2.832 lead to : = 3.833, 1 = 0.015, and
: = 0.01.
iii) Now let us compare this economy with a very similar one that only di¤ers from
having a higher money growth rate j
0
= 0.02. Recalculate the steady state values of the
variables of and discuss the long-run e¤ects of having a higher nominal money growth (non-
superneutrality).
There is no e¤ect whatsoever in the real sector of the economy since no monetary variable
enter its six-equation system. However, in the monetary sector we have
0.02
n
0
1
c
=
1
0
1 + 1
0
.
1 + 1
0
= (1 + 0.005) (1 + :
0
) .
:
0
= 0.02.
that determines a higher rate of in‡ation :
0
= 0.02, a higher nominal interest rate 1
0
= 0.025,
and a lower amount of real money balances :
0
= 2.322.
* Example of a MIU model featuring non-separability, l
cn
0.
There is a MIU economy characterized by a non-separable utility function l(c
t
. :
t
. |
t
) =
(ctn
b
t
)
1

+ log |
t
with /. c. 0, 0 < / (1 c) < 1. and a Cobb-Douglas production
function ,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with 0 < c < 1. For a quarterly-period calibration, let us
assume the values of the parameters c = 0.36, o = 0.025, j = 0.005. c = 0.51. = 3.087,
/ = 0.02, 1 = 3, and j = 0.01.
i) Compute the steady state values of ¸. :. /. n. c. |. :,1, and :.
18

|
c
ç
:
b(1ç)
= n.
(1 c):
c
/
c
= n.
| = 1 :.
¸ = :
1c
/
c
¸ = c + o/.
c:
1c
/
c1
= j + o.
/c
:
=
1
1 + 1
.
1 + 1 = (1 + j) (1 + :) .
: = j.
and inserting the calibration of parameters
3.09
|
c
0.51
:
0.0098
= n.
0.64
_
/
:
_
0.36
= n.
| = 3 :.
¸ = :
_
/
:
_
0.36
¸ = c + 0.025/.
0.36
_
/
:
_
0.64
= 0.03.
0.02c
:
=
1
1 + 1
.
1 + 1 = (1 + 0.005) (1 + :) .
: = 0.01.
Solution: / = 48.553, ¸ = 4.046, c = 2.829, n = 2.59, : = 1, | = 2, : = 3.828,
1 = 0.015, and : = 0.01.
ii) Now let us compare this economy with a very similar one that only di¤ers from
having a higher money growth rate j
0
= 0.02. Recalculate the steady state values of the
variables of and discuss the long-run e¤ects of having a higher nominal money growth (non-
superneutrality). Solution: /
0
= 48.262, ¸
0
= 4.021, c
0
= 2.818, n = 2.589, :
0
= 0.994,
|
0
= 2.006, :
0
= 2.31, 1
0
= 0.025, and :
0
= 0.02.
19
PROBLEMS
2.1. Superneutrality in the CIA model?
i) Obtain the steady state set of equations for the real sector in a competitive equilibrium
of the CIA model.
ii) Does the model display superneutrality? What can we expect from an increase in the
steady state rate of nominal money growth?
2.2. Superneutrality in the CIA model? One practical example.
There is a CIA economy where households have the following utility function l(c
t
. |
t
) =
log c
t
+ c log |
t
with c 0. and a Cobb-Douglas production function ,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with 0 < c < 1. Parameters are calibrated as follows c = 0.36, o = 0.025, j = 0.005.
c = 1.802, 1 = 3, and j = 0.01.
i) Compute the steady state solution for ¸. :. /. n. c. |. :,1, and :.
Solution: / = 48.553, ¸ = 4.046, c = 2.833, n = 2.589, : = 1, | = 2, : = 2.833,
1 = 0.015, and : = 0.01
ii) Repeat the exercise for a higher rate of nominal money growth j
0
= 0.02. Compare
results.
Solution: /
0
= 48.247, ¸
0
= 4.021, c
0
= 2.814, n = 2.589, :
0
= 0.994, |
0
= 2.006,
:
0
= 2.814, 1
0
= 0.025, and :
0
= 0.02.
2.3. Superneutrality in the shopping time model?
i) Obtain the steady state set of equations for the economy in the competitive equilibrium
of the shopping time model.
ii) Can the real sector be solved separately? Does the model display superneutrality?
iii) What e¤ects on the real and monetary sectors can we expect from an increase in
the steady state rate of nominal money growth if :
cn
= 0, i.e., the shopping time function
displays consumption-money separability?
2.4. Superneutrality in the shopping time model? One practical example.
In a shopping time economy households have the following utility function l(c
t
. |
t
) =
log c
t
+ c log |
t
with c 0. a Cobb-Douglas production function ,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with
0 < c < 1, and a shopping time function.
:(c
t
. :
t
) =
_
_
_
0 if c
t
= 0
:
0
+ :
1
c
1
1s
2
t
:
s
2
1s
2
t
if c
t
0
_
_
_
.
20
with :
0
. :
1
0, and 0 :
2
1.
Parameters are calibrated as follows c = 0.36, o = 0.025, j = 0.005. c = 1.731, 1 = 3,
:
0
= 0.056. :
1
= 0.01. :
2
= 0.85, and j = 0.01.
i) Compute the steady state solution for ¸. :. /. n. c. |. :. :,1, and :.
Solution: / = 48.553, ¸ = 4.046, c = 2.832, n = 2.589, : = 1, | = 1.94, : = 0.06. : =
3.996, 1 = 0.015, and : = 0.01
ii) Repeat the exercise for a higher rate of nominal money growth j
0
= 0.02. Compare
results.
Solution: /
0
= 48.116, ¸
0
= 4.01, c
0
= 2.806, n = 2.589, :
0
= 0.991, |
0
= 1.947, :
0
= 0.062,
:
0
= 3.673, 1
0
= 0.025, and :
0
= 0.02.
2.5. Inelastic labor supply in the MIU model. Suppose that households supply labor
inelastically. If so, their labor supply is constant and leisure time is also constant (unless
the model incorporates shopping time). Let us normalize at :
c
= 1 so that labor can be
eliminated from the competitive equilibrium. Analyze the property of superneutrality in
a MIU model featuring non-separability between consumption and real money balances.
Proceed by looking at the steady state equations of its competitive equilibrium.
2.6. Inelastic labor supply in the transactions technology model. Let us keep the inelastic
labor supply assumption in the transactions technology model. Let us normalize at :
c
= 1
so that labor can be eliminated from the competitive equilibrium. Analyze the property
of superneutrality. Proceed by looking at the steady state equations of its competitive
equilibrium.
21
3 Welfare analysis
In this chapter we will focus attention on the welfare e¤ects of money and monetary policy
in the long-run. Thus, the decentralized competitive equilibrium analysis of the previous
chapters will be joined by the social planner program that will maximize social welfare
subject to the overall resources constraint. The MIU model will be utilized through this
chapter and the deterministic scenario will be maintained aiming at long-run analysis.
3.1 The social planner program
The objective of the social planner is to reach the maximum social welfare while satisfying
the overall resources constraint and the time constraint. The social planner takes the util-
ity function of the representative household to de…ne the level of welfare of the economy.
The basic question then is the de…nition of a long-run monetary policy consistent with the
maximum social welfare criterion and the symmetric competitive equilibrium.
The social planner optimizing program is in period t
`cr
nt
l(c
t
. :
t
. |
t
) + ,l(c
t+1
. :
t+1
. |
t+1
) + ,
2
l(c
t+2
. :
t+2
. |
t+2
)......
subject to
,(:
t+)
. /
t+)
) c
t+)
/
t+1+)
+ (1 o)/
t+)
= 0. , = 0. 1. 2. ....
which gives the following …rst order condition
l
nt
= 0.
Monetary policy will be optimal in the long-run if it leads to satiation on monetary services,
i.e., if households use up all the positive marginal returns of real money.
5
3.2 The optimal rate of in‡ation
What is the long-run optimal rate of in‡ation then? The answer should be straightforward:
the one that makes the households exploit all the transaction facilitating services of money.
In other words, the amount of money demand will increase as long as it has some positive
5
It is implicitly assumed that there exists an actual satiation point for real money balances, not only
asymptotically l
n
= 0 when : 1.
22
value for money holders. This is a well-known result obtained by the Nobel Prize economist
Milton Friedman (see Friedman (1969)).
Now we should say something about how to proceed when de…ning our long-run monetary
policy strategy. The target is l
n
= 0 and the instrument is the nominal money growth j
as assumed to be fully controllable by the central bank. In the long-run, nominal money
growth and in‡ation have an identical value. Therefore, we can indistinctly refer to “optimal
in‡ation”, “optimal money growth”, or “optimal monetary policy” when talking about long-
run analysis in this type of models. Let us de…ne this optimal …gure by looking at the money
demand behavior of the households in the MIU model
l
n
l
c
=
1
1 + 1
.
The central bank may exert some in‡uence on the amount of real money balances through
the money demand dependence on the nominal interest rate.
6
When setting the optimality
condition l
n
= 0, the money demand equation leads to the optimal nominal interest rate
1

= 0.
Intuitively, if the opportunity cost of money holdings is zero households will satiate them-
selves with monetary services. This is the argument of the so-called Chicago Rule that in
terms of the optimal rate of in‡ation is expressed as
:

=
j
1 + j
.
This result is easily obtained by inserting the 1

= 0 condition into the nominal interest rate
de…nition 1 +1 = (1 +j)(1 +:). The Chicago Rule states that the optimal rate of in‡ation
is negative and approximately equal to the rate of intertemporal discount (or the real rate of
interest). This rate makes the nominal interest rate equal to zero and real money balances
equal to its satiation level.
3.3 The welfare cost of in‡ation
We have just seen that the optimal rate of in‡ation is a negative small number. In modern
economies real rates of interest are at around 2% per year so that the optimal price evolution
should be near 2% decline per year. However, it is quite rare to see continuous de‡ation
6
The transmission mechanism channel in the CIA model is by a consumption/leisure substitution (to be
worked out in Problem 3.1).
23
episodes in the real world.
7
Therefore if the rate of in‡ation of one economy is positive in
a long-run perspective, there should be some welfare cost according to the Chicago Rule.
Moreover, this would be a permanent welfare cost since referred to a steady state analysis.
How large is this welfare cost? Is a 2% for example close enough to the optimal rate of
in‡ation in the sense of having a low welfare cost?
Let us try to give an answer to these question with our monetary models. Our approach
follows the analysis of the Nobel Prize economist Robert Lucas in Lucas (2000), and also
appearing in Walsh (1998), pages 61-64. The welfare cost of one given positive rate of
in‡ation is measured as the amount of consumption necessary to gain utility in the utility
function in order to be indi¤erent to the optimal rate of in‡ation economy. This consumption-
equivalent value is reported as a percentage of steady state output.
Here comes one exercise as an example of a welfare cost of in‡ation calculation:
There is a MIU economy where households have a separable utility function l(c
t
. :
t
. |
t
) =
log c
t
+ c log |
t
+ / (log :
t
/:
t
) with c,/. / 0. and a Cobb-Douglas production function
,(:
o
t
. /
t
) =
_
:
o
t
_
1c
/
c
t
with 0 < c < 1. For a quarterly-period calibration, let us assume
the values of the parameters c = 0.36, o = 0.025, j = 0.005, c = 1.828, / = 0.02, / = 0.1,
1 = 3, and j = 0.01.
i) What is the optimal rate of in‡ation?
:

=
j
1 + j
= 0.004975.
which is -1.99% per year.
ii) How much is the welfare cost of the current steady state 4% annual rate of in‡ation?
The solution for the real economy sector is / = 48.553, ¸ = 4.046, c = 2.832, n = 2.589,
: = 1, and | = 2 (see page 17). The monetary sector is de…ned in steady state by the
following equations
0.02
_
1
n
0.1
_
1
c
=
1
1 + 1
.
1 + 1 = (1 + 0.005) (1 + :) .
: = 0.01.
where inserting the steady state consumption c = 2.832 leads to : = 3.609, 1 = 0.015, and
: = 0.01.
7
Here we need to mention the Japanese de‡ationary experience from the mid-90’s to present time.
24
Plugging c = 2.832, : = 3.609, and | = 2 in the utility function the level of utility
reached is l(2.832. 3.609. 2) = 2.3265.
Now we recalculate the steady state solution at the optimal rate of in‡ation :

=
0.004975. This rate leads to a zero nominal interest rate that changes the monetary sector
to : = 10, 1 = 0, and : = 0.004975. The real economy sector is not a¤ected as the utility
function features money-consumption separability. In turn the steady state values entering
the utility function under the optimal rate of in‡ation are c = 2.832, : = 10, and | = 2.
The level of utility goes up to l(2.832. 10. 2) = 2.3341.
The amount of consumption needed to compensate the loss of welfare at : = 0.01 is
c = 2.8536 because l(2.8536. 3.609. 2) = 2.3341. Subsequently, if consumption is raised by
2.8536 2.832 = 0.0216 units, households would be indi¤erent between the current and
the optimal in‡ation scenario. The increase in consumption required is in terms of output
0.0216,4.046 = 0.0053 which means that the welfare cost of a steady state 4%annual in‡ation
is a permanent 0.53% of output.
PROBLEMS
3.1. Verify that the long-run optimal rate of in‡ation is provided by the Chicago Rule
in:
i) The CIA model.
ii) The transactions technology model.
iii) The shopping time model.
3.2. In the shopping time economy described by problem 2.4, calculate the welfare gains
of obtaining price stability in the long-run by moving down the steady state rate of in‡ation
from : = 0.01 to : = 0.0.
3.3. Steady-state analysis in a transactions technology model.
There is a monetary economy in which all households have the same logarithmic utility
function whose arguments are consumption c
t
and leisure |
t
l(c
t
. |
t
) = log c
t
+ c log |
t
.
with c 0.0. They maximize current and future utility values discounted at the rate
, = (1 + j)
1
with j 0.0. These households also use the Cobb-Douglas production
technology
¸
t
= ,(/
t
. :
o
t
) = /
c
t
_
:
o
t
_
1c
.
25
with 0.0 < c < 1.0, in order to obtain units of output ¸
t
that sell in a perfect competi-
tion market. There is also a labor perfect competition market where households demand
labor :
o
t
and place their labor supply at the real wage n
t
. The process of capital accumu-
lation /
t
involves a constant rate of depreciation per period equal to o. Finally, households
need to take some output resources to pay the transaction costs due to the purchases of
consumption goods. In particular there is a transactions-technology function (entering the
budget constraint) that provides the amount of transaction costs /
t
depending positively on
the level of consumption c
t
, and negatively (up to some satiation point) on the amount of
transactions-facilitating real money balances :
t
/
t
= /(c
t
. :
t
) = /
1
c
t
+ :
I
2
t
+ /
3
:
t
with /
1
. /
2
. /
3
0.0.
i) Represent the steady-state equations of the competitive equilibrium of this economy.
Can the real sector be solved separately from the monetary sector? Does the model display
superneutrality?
ii) The parameters of this economy (calibrated for quarterly observations) take the fol-
lowing values: c = 1.8, j = 0.005, c = 0.36, /
1
= 0.05, /
2
= 2.0, /
3
= 0.006, o = 0.025, the
total number of units of time available is 1 = 3.0. The monetary authorities print money
at a 1% per quarter growth rate, j = 0.01. Solve the model in steady state for the (ten)
endogenous variables ¸, n, /, :, c, |, :, /, 1, and :.
iii) Optimal long-run monetary policy. Solve again the model in steady state now as-
suming that the central bank runs the optimal long-run policy. Therefore, the monetary
authorities apply the Chicago rule and set the average nominal interest rate at 0.0. Compare
the results with the case of ii).
iv) Calculate the welfare cost of a 4% annualized rate of in‡ation in this economy.
3.4. Optimal monetary policy in a shopping-time model.
A monetary general-equilibrium economy is formed by identical households whose utility
function is logarithmic in both consumption c
t
and leisure |
t
l(c
t
. |
t
) = log c
t
+ c log |
t
.
with c 0.0. As usual, they maximize current and future utility values discounted at the
rate , = (1 + j)
1
with j 0.0. These households obtain income from producing units of
output, ¸
t
, with the following Cobb-Douglas production technology
¸
t
= ,(/
t
. :
o
t
) = /
c
t
_
:
o
t
_
1c
.
26
where /
t
is the stock of capital, :
o
t
is the labor demand, and 0.0 < c < 1.0. The labor
market operates in perfect competition and households place the amounts of labor demand
labor and labor supply that maximize their intertemporal utility at the (market-clearing)
real wage n
t
. Households spend their income on consumption, capital accumulation, net
purchases of government bonds and net increases on money balances. The process of capital
accumulation involves a constant rate of depreciation per period equal to o. Finally, pur-
chases of consumption goods are time consuming. Thus, a shopping time function provides
the amount of time devoted to purchases depending positively on the level of consumption
c
t
, and negatively (up to some satiation point) on the amount of transactions-facilitating
real money balances :
t
:
t
= :(c
t
. :
t
) = :
1
c
2
t
:
t
+ :
2
:
t
with :
1
. :
2
0.0.
i) Represent the steady-state equations of the competitive equilibrium of this economy.
Can the real sector be solved separately from the monetary sector? Does the model display
superneutrality?
ii) The parameters of this economy (calibrated for quarterly observations) take the fol-
lowing values: c = 1.672, j = 0.005, c = 0.36, :
1
= 0.0156, :
2
= 0.001, o = 0.025, the
total number of units of time available is 1 = 3.0. The monetary authorities print money
at a 2.5% per quarter growth rate, j = 0.025. Solve the model in steady state for the (ten)
endogenous variables ¸, n, /, :, c, |, :, :, 1, and :.
iii) Optimal long-run monetary policy. Solve again the model in steady state now assum-
ing that the central bank runs the optimal long-run policy. Compare the results with the
case of ii).
iv) Calculate the welfare cost of the 10% annualized rate of in‡ation held in the economy
described in ii).
27
REFERENCES
Brock, W.A. (1974), “Money and growth: the case of long-run perfect foresight”, Interna-
tional Economic Review, 15, 750-777.
Friedman, M. (1969), “Optimum quantity of money and other essays”, Aldine Press.
Lucas, R.E. Jr (2000), “In‡ation and welfare”, Econometrica, 68 (2), 247-274.
McCallum, Bennett T. (1989), “Monetary Economics. Theory and Policy”, Macmillan
Publishing Company Eds. New York, USA.
McCallum, Bennett T. (1998), “Solutions to linear rational expectations models: a compact
exposition”, Economic Letters 61, 143-147.
McCallum, Bennett T., (1999), “A Course in Macro and Monetary Economics”, Lecture
Notes. GSIA, Carnegie Mellon University.
Sidrauski, M. (1967), “Rational choice and patterns of growth in a monetary economy”,
American Economic Association Papers and Proceedings, 57, 534-544.
Walsh, Carl E. (2003), “Monetary Theory and Policy”, 2nd edition. MIT Press Eds. Cam-
bridge, MA.
28
PART 2. Short-run analysis.
Reading list:
McCallum, Bennett T., (1989). “Monetary Economics. Theory and Policy”. Macmillan
Publishing Company Eds. New York, USA. Chapter 8, pages 145-173, and Chapters 11-12,
pages 221-248.
McCallum, Bennett T., (1999). “A Course in Macro and Monetary Economics”. Lecture
Notes. GSIA, Carnegie Mellon University. Chapters 3-6, pages 26-106.
Walsh, Carl E., (2003). “Monetary Theory and Policy”. 2nd edition. MIT Press Eds.
Cambridge, MA. Chapter 5, pages 199-269; and Chapter 11, pages 517-558.
Woodford, M., (2003). “Interest and prices: Foundations of a theory of monetary policy”.
Princeton University Press.
4 Solutions to Linear Rational Expectations Models
In this second part of the course attention is placed on the dynamic period-to-period evolution
of the models, the so-called short-run analysis. The deterministic world of the steady state
analysis of the …rst lectures is abandoned for an economy with uncertainty. Two new elements
will be introduced: stochastic terms (shocks) and rational expectations operators. Prior to
getting into the monetary analysis in the short-run, we must take some time to learn how
to solve linear rational expectations models.
4.1 The Minimal State Variables (MSV) solution
Let us denote 1 as the rational expectation operator. Then, 1
t
¸
t+1
is the rational expectation
of ¸
t+1
in period t and 1
t
¸
t+1
¸
t+1
is its expectational error. A rational expectation (RE)
is de…ned as the expectation over a future variable whose expectational error is unrelated to
the set of available information.
8
In this regard it is considered as the “best” expectation
for the economic agent because it exploits all the available information.
9
Nonlinear models with RE are quite di¢cult to solve. Thus, the original non-linear
equations of an optimizing model with RE are usually approximated by log-linear equations
8
See McCallum (1989), pages 146-147, for the proof.
9
By contrast, adaptative expectations may have systematic expectational errors that could be avoided by
using correctly the available information.
29
representing the variables in deviations from the steady state solution. Loglinearizing tech-
niques are well described in Uhlig (1999). In this chapter, we will directly work on linear
equations.
One model formed by a linear system of equations that incorporates rational expectation
operators is said to be a Linear RE Model. The Minimal State Variable solution is the
one written as a linear function with the minimal set of state variables. The minimal set
of state variables contains two types of variables: predetermined and shocks. So, the way
of proceeding is by selecting the minimal set of state variables and …nding the coe¢cients
attached to these state variables.
Sometimes Linear RE Models have multiple solutions. In those cases, the MSV solution
has the desirable property of being the bubble-free (fundamental) solution, i.e., it rules out
explosive dynamic patterns.
4.2 Solution procedure: The Undetermined Coe¢cients technique
One univariate example will serve to explain the procedure to …nd the MSV solution suing
the undetermined coe¢cients technique in simple models.
10
The dynamic evolution of ¸
t
is
governed by the following linear equation
¸
t
= c + /1
t
¸
t+1
+ c¸
t1
+ n
t
. (1)
with n
t
being a white noise random perturbance, n
t
`(0. o
2
&
). Since ¸
t1
and n
t
are the
two state variables, the MSV solution for ¸
t
should take the form
¸
t
= c
0
+ c
1
¸
t1
+ c
2
n
t
. (2)
Now we need to …gure out the values of the coe¢cients c
0
, c
1
, and c
2
. According to our
conjecture for ¸
t
the value of 1
t
¸
t+1
would be determined by
1
t
¸
t+1
= c
0
+ c
1
¸
t
. (3)
Inserting (3) into (1) yields
¸
t
= c + /c
0
+ /c
1
¸
t
+ c¸
t1
+ n
t
.
10
Some computer routine is required to solve more sophisticated models. The paper by McCallum (1998)
provides the guidelines for programming such a routine. One example to be used on MatLab is written at
Michael Woodford’s website (http://www.columbia.edu/~mw2230/)
30
and moving /c
1
¸
t
to the left hand side of the equation
(1 /c
1

t
= c + /c
0
+ c¸
t1
+ n
t
. (4)
By substituting ¸
t
from equation (2) in (4), it is obtained
(1 /c
1
)c
0
+ (1 /c
1
)c
1
¸
t1
+ (1 /c
1
)c
2
n
t
= c + /c
0
+ c¸
t1
+ n
t
. (5)
Now the undetermined coe¢cients technique consists of making the coe¢cients attached to
the left hand side of (5) equal to their value on the right hand side. It turns out into the
three-equation system
(1 /c
1
)c
0
= c + /c
0
. (6a)
(1 /c
1
)c
1
= c. (6b)
(1 /c
1
)c
2
= 1. (6c)
Notice that (6b) determines the value of coe¢cient c
1
from the second order equation
/c
2
1
c
1
+ c = 0.
which happens to have two roots, c
+
1
=
1+
p
14bc
2b
and c

1
=
1
p
14bc
2b
. Therefore, there are
two solutions for the triplet of coe¢cients, one coming from c
+
1
and the other one from c

1
.
It is crucial then to determine which of the two is the bubble-free MSV solution. The MSV
solution will be found by looking at the implications of the solution form (2) in some relevant
particular case. Hence, if c = 0 the evolution of ¸
t
is not dependant of its lagged value ¸
t1
.
In such situation, the value of the coe¢cient attached to ¸
t1
in (2) should be c
1
= 0 and
the minimal number of state variables would drop from two to one. Now we can verify that
c

1
= 0 when c = 0 whereas c
+
1
=
1
b
. Consequently, the MSV solution is provided by c

1
and
the bubble solution will be given by c
+
1
.
Taking c
1
=
1
p
14bc
2b
in (6a) and rearranging terms result in
c
0
=
c
1
2
/ +
_
14bc
2
.
Similarly, taking c
1
=
1
p
14bc
2b
in (6c) and rearranging terms result in
c
2
=
2
1 +
p
1 4/c
.
31
The MSV solution for ¸
t
is c
0
=
o
1
2
b+
p
14bc
2
, c
1
=
1
p
14bc
2b
, and c
2
=
2
1+
p
14bc
. In turn, the
dynamic evolution of ¸
t
can be expressed as linearly dependant of a constant term and the
state variables as follows
¸
t
=
o
1
2
b+
p
14bc
2
+
1
p
14bc
2b
¸
t1
+
2
1+
p
14bc
n
t
PROBLEMS.
4.1. This problem represents the Cagan model and has been taken from McCallum
(1999), pages 26-28. A bivariate money market model consists of the money demand and
money supply functions
log `
t
log 1
t
= ¸ c(1
t
log 1
t+1
log 1
t
) + n
t
.
log `
t
= j
0
+ j
1
log `
t1
+
t
.
where ¸, c, j
0
0, 0 < j
1
< 1, and both n
t
and
t
are white-noise shocks.
i) Find the MSV solution.
ii) How would a money supply shock (“monetary surprise”) would a¤ect the price level?
4.2. Consider a market in which the quantity supplied is
¡
t
= c
0
+ c
1
j
t
+ c
2
¡
t1
, with c
0
. c
1
0 and 0 < c
2
< 1,
and the quantity demanded is
¡
t
= ,
0
+ ,
1
j
t
+ ,
2
(1
t
j
t+1
j
t
) + ·
t
,
where ,
0
. ,
2
0, ,
1
< 0, and ·
t
is a white-noise disturbance. This linear RE model has two
solutions. Discriminate between the fundamental MSV solution and the bubble solution.
32
5 The Optimizing IS-LM Model
In this chapter an IS-LM optimizing model will be described and found its MSV solution.
Two scenarios regarding price behavior will be considered. First, the price level will be
assumed to be constant. This assumption is literally taken from the standard textbook-style
IS-LM model. In these models the constant-price case is meant to re‡ect the extreme case
of a Keynesian economy with a horizontal Aggregate Supply curve. Under our second price
scenario, the price level will be endogenous. Moreover, the price level will adjust to clear
the perfect competition goods market. Thus, our second scenario corresponds to a standard
Classical economy with a vertical Aggregate Supply curve.
5.1 Constant-Price Economy
In this second part of the course, we will set apart the production sector fromthe consumption
sector. Households raise income from the earnings obtained for the labor services supplied to
…rms. Therefore, the budget constraint of the representative household is written as follows
n
t
:
c
t
+ :
I
t
/
t
+ q
t
= c
t
+ /
t+1
(1 o)/
t
(1 + :
t
)
1
/
t+1
+ /
t
:
t
+ (1 + :
t
)
1
:
t1
. (1)
For simplicity, our utility function is separable in consumption, real money, and work hours
as follows
l(·
t
. c
t
. :
t
. :
c
t
) = exp(·
t
)
c
1o
t
1 o
+
:

t
1 ¸

(:
c
t
)
1+i
1 + i
nit/ o. ¸. . . i 0. (2)
where there is a white-noise consumption preference shock ·
t
`(0. o
2
u
).
Taking the previous lines into consideration and recalling the constant-capital assump-
tion, the optimizing program for the representative household becomes
`cr
ct,b
t+1
,nt,a
s
t
1
t
1

)=0
,
)
_
exp(·
t+)
)
c
1o
t+)
1 o
+
:

t+)
1 ¸

(:
c
t
)
1+i
1 + i
_
subject to
1
t
[n
t+)
:
c
t+)
+:
I
t
/+q
t+)
c
t+)
o/(1+:
t+)
)
1
/
t+1+)
+/
t+)
:
t+)
+(1+:
t+)
)
1
:
t1+)
] = 0. , = 0. 1. 2. ....
33
which results in the …rst order conditions
exp(·
t
)c
o
t
`
t
= 0. (c
)cc
t
)
`
t
(1 + :
t
)
1
+ ,1
t
`
t+1
= 0. (/
)cc
t+1
)
:
¸
t
`
t
+ ,1
t
_
`
t+1
(1 + :
t+1
)
1
_
= 0. (:
)cc
t
)
(:
c
t
)
i
+ `
t
n
t
= 0. (:
c,)cc
t
)
n
t
:
c
t
+ :
I
t
/ + q
t
c
t
o/ (1 + :
t
)
1
/
t+1
+ /
t
:
t
+ (1 + :
t
)
1
:
t1
= 0. (`
)cc
t
)
Inserting the Lagrange multipliers from the consumption …rst order condition in (/
)cc
t+1
)
yields the consumption structural equation
exp(·
t
)c
o
t
1 + :
t
= ,1
t
exp(·
t+1
)c
o
t+1
.
which happens to be a non-linear relation. Taking logs on both sides and using log(1+:
t
) ' :
t
lead to the following log-linear approximation
log c
t
= 1
t
log c
t+1

1
o
(:
t
j) +
1
o
·
t
.
Let us denote ”hat” variables as per-unit deviations from steady state. For example, ´c
t
=
log
_
ct
c
ss
_
where the :: superscript represents the steady-state …gure. Then, the log-linear
consumption equation becomes
´c
t
= 1
t
´c
t+1

1
o
(:
t
:
cc
) +
1
o
·
t
. (3)
where :
t
:
cc
represents the deviation with respect of the steady-state real interest rate.
The overall resources constraint for this economy can be obtained by plugging both the
government budget constraint and the labor market equilibrium condition into the household
budget constraint. It results in the equation
¸
t
= c
t
+ o/.
where ¸
t
= ,(.
t
. :
t
). The overall resources constraint in logarithmic deviations from steady
state is
11
´ ¸
t
=
c
ss
j
ss
´c
t
. (4)
11
Notice that j
|
= j
ss
exp(´ j
|
). Then, by using the approximation exp(´ j
|
) ' 1 + ´ j
|
, it is obtained j
|
'
j
ss
+ j
ss
´ j
|
. The same procedure applied to c
|
brings about equation (4). See Uhlig (1999) for details on
loglinearizing techniques.
34
Equations (3) and (4) imply the following dynamic behavior of output
´ ¸
t
= 1
t
´ ¸
t+1

1
o
c
ss
j
ss
(:
t
:
cc
) +
1
o
c
ss
j
ss
·
t
. (5)
This is the so-called optimizing IS curve because its negative relationship between output
and the real interest rate resembles the ad hoc IS setup from traditional Macroeconomic
textbooks. Notice the presence of 1
t
´ ¸
t+1
in the equation, which gives a forward-looking
pattern on output dynamic evolution.
In a constant-price economy, the nominal and real interest rate are identical because the
rate of in‡ation is zero at all times.
12
Therefore, equation (5) can also be written as
´ ¸
t
= 1
t
´ ¸
t+1

1
o
c
ss
j
ss
(1
t
1
cc
) +
1
o
c
ss
j
ss
·
t
. (6)
Our next step is to …nd the MSV solution for ´ ¸
t
. In order to do that, we need to specify
some dynamic behavior of the nominal interest rate due to its presence in (6). Hence, there
will be a two-equation system to be solved for ´ ¸
t
and 1
t
. It is assumed that the central bank
implements a monetary policy rule looking for stabilizing output around its steady state
value
1
t
= 1
cc
+ j
2
´ ¸
t
with j
2
0. (7)
If ´ ¸
t
is greater than zero the central bank would raise the interest rate so as to make output
fall. Likewise, if the economy is in the downturn with ´ ¸
t
< 0 the central bank would cut the
interest rate to expand aggregate demand as implied by the IS curve (6).
In the end, the model consists of the pair of equations
´ ¸
t
= 1
t
´ ¸
t+1
/ (1
t
1
cc
) + /·
t
. (8a)
1
t
= 1
cc
+ j
2
´ ¸
t
. (8b)
where / =
1
o
c
ss
j
ss
. Since the only state variable is the demand shock ·
t
, the MSV solution will
take the form
´ ¸
t
= c
1
·
t
.
1
t
1
cc
= c
2
·
t
.
Using the undetermined coe¢cients technique, the solution for the coe¢cients is c
1
=
b
1+bj
2
and c
2
=
bj
2
1+bj
2
. Both …gures are strictly positive re‡ecting that output and the nominal
interest rate will increase if there is a positive demand shock ·
t
. This can be represented in
a (1. ´ ¸) diagram as a shift of the IS curve to the right.
12
Taking logs in the de…nition of the nominal interest rate leads to the Fisher equation that relates nominal
and real interest rates as follows 1
|
= r
|
1
|
¬
|+1
.
35
5.2 Flexible-Price Economy
Let us have the IS-LM model with endogenous price adjustments to guarantee a general equi-
librium. Thus, the price level is assumed to be fully ‡exible to restore the full-employment
level of output after any demand or technology shock. Firms decide on labor demand as
they seek to maximize pro…ts by producing output with a given technology. For simplicity,
we will assume that the stock of capital is constant and the only variable input for the …rm
is labor. Subsequently, the production technology can be represented by this Cobb-Douglas
production function that incorporates a labor-augmenting technology shock, .
t
,
,(.
t
. :
t
) =
_
exp(.
t
):
o
t
_
1c
nit/ 0 < c < 1, (9)
and where the constant capital term has been normalized to the value / = 1.0. The tech-
nology shock follows the AR(1) stochastic process
.
t
= j.
t1
+
t
.
where
t
is a white-noise technology innovation. A representative …rm would maximize this
intertemporal pro…t function
1
t
1

)=0
,
)
_
,(.
t+)
. :
o
t+)
) n
t+)
:
o
t+)
_
.
subject to the production technology available (9) in period t and future periods. The …rst
order condition for the optimal demand of labor in period t implies
,
a
d
t
n
t
= 0. (10)
which leads to the standard micro-founded prescription of equation the marginal product of
labor to the real wage.
Turning to the household sector, the labor supply curve is reached by combining
_
:
c,)cc
t
_
with
_
c
)cc
t
_
from above
(:
c
t
)
i
exp(·
t
)c
o
t
= n
t
. (11)
which implies that the marginal rate of substitution between work hours and consumption
must be equal to the real wage. Combining (9) and (11), it yields
(:
c
t
)
i
exp(·
t
)c
o
t
= (1 c)
_
:
o
t
_
c
(exp(.
t
))
1c
.
36
that implies that the labor market is in equilibrium when the households’ marginal rate of
substitution and the …rms’ marginal product of labor coincide. The price level will move
as necessary to adjust the real wage at the value that makes these two variables identical.
Inserting the labor market equilibrium condition (:
c
t
= :
o
t
= :
t
), taking logs, and dropping
constant terms, we obtain
i
´
:
t
·
t
+ o
´
c
t
= c
´
:
t
+ (1 c) .
t
, (12)
where
´
:
t
and
´
c
t
are the (market-clearing) levels of employment and consumption. The
Cobb-Douglas production technology in loglinear terms for full-employment labor is
¸
t
= (1 c) .
t
+ (1 c)
´
:
t
,
which implies
´
:
t
= (1 c)
1
¸
t
.
t
(13)
The substitution of (13) into (12) results in
c + i
1 c
¸
t
= ·
t
o
´
c
t
+ (1 + i) .
t
.
where, using (4), we can replace
´
c
t
for
j
ss
c
ss
´
¸
t
to reach this equation for full-employment output
´
¸
t
=
1 c
c + i + /
1
(1 c)

t
+ (1 + i) .
t
) , (14)
At this point, we are able to present the ‡exible-price equation as the market-clearing
condition
´ ¸
t
=
´
¸
t
. (15)
that will determine endogenously the dynamic behavior of the price level. A variable price
level makes the rate of in‡ation also variable and the nominal and real interest rate no
longer coincide. Monetary policy will now probably aim to stabilize both in‡ation and
output around its steady state values. Thus, the monetary policy rule sets the nominal
interest rate in response to changes in both ´ ¸
t
and :
t
as follows
1
t
= 1
cc
+ j
1
(:
t
:
cc
) + j
2
´ ¸
t
. (16)
with j
1
1 and j
2
0. This type of monetary policy rule is called a Taylor rule because it
was …rst proposed by John Taylor (see Taylor, 1993). The imposed condition j
1
1 re‡ects
the Taylor principle.
13
13
The Taylor principle argues that responses of the nominal interest rate to in‡ation deviations must be
greater than one-by-one so that the real interest rate moves in the same direction as the nominal interest
rate.
37
Hence, taking the IS curve derived above with variable in‡ation and equations (14)-(16)
into account, the ‡exible-price economy is characterized by the following three equations
´ ¸
t
= 1
t
´ ¸
t+1
/(1
t
1
t
:
t+1
:
cc
) + /·
t
. (17a)
1
t
1
cc
= j
1
(:
t
:
cc
) + j
2
´ ¸
t
. (17b)
´ ¸
t
=
1 c
c + i + /
1
(1 c)

t
+ (1 + i) .
t
) . (17c)
that can be solved for the three endogenous variables ´ ¸
t
, :
t
, and 1
t
. There are three state
variables in the system: the (predetermined) lag of the AR(1) technology shock, .
t1
, the
innovation on technolgy,
t
, and the consumption preference white-noise shock, ·
t
, and the
AR(1) technology shock, .
t
. In turn, our conjecture of the MSV solution is
´ ¸
t
= c
11
.
t1
+ c
12

t
+ c
13
·
t
.
:
t
:
cc
= c
21
.
t1
+ c
22

t
+ c
23
·
t
.
1
t
1
cc
= c
31
.
t1
+ c
32

t
+ c
33
·
t
.
PROBLEMS
5.1. Obtain the money demand LM curve from the model described in the …rst section
of this chapter.
i) Express the LM curve depending on ´ ¸
t
. ·
t
, and 1
t
(use …rst order conditions, and the
approximations 1
t
'
1t
1+1t
and 1
t
' 1
cc
(1 + log
_
1t
1
ss
_
)
ii) Find the MSV solution for ´ :
t
.
iii) Discuss what may happen to the LM curve if there is a positive demand shock.
5.2. The constant-price model is calibrated at o = 2,
c
ss
j
ss
= 0.7, and j
2
= 0.5.
i) Calculate the impulse response functions for ´ ¸
t
. and 1
t
1
cc
of a unit consumption
preference (demand) shock. Take up to 4 periods after the shock (1 year).
5.3. Find the MSV solution for the ‡exible-price model described in the text.
i) What is the impact of a positive demand shock ·
t
on ´ ¸
t
. :
t
:
cc
, and 1
t
1
cc
?
ii) What is the impact of a positive technology shock
t
on ´ ¸
t
. :
t
:
cc
, and 1
t
1
cc
?
5.4. The ‡exible-price model can be represented in a (:. ´ ¸) diagram with an Aggregate
Supply (AS) function and Aggregate Demand (AD) function. The AS function displays the
supply-side behavior to clear the labor market as collected by (17c), whereas the AD curve
38
is the result of combining the IS demand curve (17a) with the Taylor-type monetary policy
rule (17b).
i) Discuss the shifts on either the (AD) or the (AS) fucntions after a positive technology
shock and its implications on : and ´ ¸.
ii) Discuss the shifts on either the (AD) or the (AS) fucntions after a positive demand
shock and its implications on : and ´ ¸.
5.5. The ‡exible-price model is calibrated at o = 2,
c
ss
j
ss
= 0.7, j
1
= 1.5, j
2
= 0.5,
c = 0.36, i = 4.0, and j = 0.90.
i) Calculate the impulse response functions for the three endogenous variables of a unit
innovation on the technology shock. Take up to 4 periods after the shock (1 year).
ii) Calculate the impulse response functions for the three endogenous variables of a unit
innovation on the consumption preference (demand) shock. Take up to 4 periods after the
shock (1 year).
39
6 Sticky prices and the New Keynesian model
Over the past ten years or so, structural monetary models with sticky prices have become
increasingly popular for dynamic macroeconomic analysis. There are two major reasons
for the uprising of this approach that also justify its use in this course. First, the Phillips
curve de…ning the dynamic evolution of in‡ation is assumed to be independent from the
monetary/…scal policy regime because it is obtained from rational (optimizing) decisions
under any implemented policy. In other words, the Phillips curve is not subject to the Lucas
critique. Secondly, nominal rigidities can help capturing the short-run real e¤ects of these
policies observed in actual data.
Price stickiness arises when setting the selling price. Here we follow the …xed probabilities
scheme introduced in Calvo (1983) and quite popular today.
14
Firms are not allowed to
set the optimal price with an exogenous constant probability. Interestingly, the in‡ation
dynamics generated by the Calvo constant probability of optimal pricing are equivalent to
those obtained when assuming the presence of menu costs á la Rotemberg (1982) with a
quadratic adjustment cost function for price changes (see Roberts, 1995; or Khan, 2005).
Other alternatives of price stickiness are Taylor’s (1980) staggered prices, and the Fuhrer
and Moore’s (1995) price contracts speci…cation which are both described in Walsh (2003,
chapter 5).
6.1 The New Keynesian Phillips Curve
Price setting takes place in a monopolistic competition framework as in Dixit and Stiglitz
(1977). Firms are no longer alike as producing a di¤erentiated consumption good. They set
the selling price while the amount produced meets the monopolistic competition demand
function. Thus, output produced by the i
tI
household in period t is
15
¸
t
(i) =
_
1
t
(i)
1
t
_
0
¸
t
. (1)
14
As several examples, see Yun (1996), Erceg, Henderson, and Levin (2000), Smets and Wouters (2003),
Christiano, Eichenbaum, and Evans (2005), and Casares (2007a, 2007b).
15
It is implicitly assumed that a competitive …rm could produce the consumption bundle (by using the
Dixit-Stiglitz output aggregator technology de…ned in the text to assemble di¤erentiated goods). If so,
the pro…t-maximizing criterion leads to demand equation (1), and the zero-pro…t condition leads to the
Dixit-Stiglitz aggregate price level de…nition.
40
in which o is the elasticity of substitution between di¤erentiated goods, 1
t
=
_
_
1
0
[1
t
(i)]
10
di
_
1¸(10)
is the aggregate Dixit-Stiglitz price level, and ¸
t
=
_
_
1
0

t
(i)]
(01)¸0
di
_
0¸(01)
is the Dixit-
Stiglitz aggregate output.
The introduction of market power for setting prices implies that the producer-speci…c
labor demand :
o
t
(i) is the one needed to obtain the amount of di¤erentiated output ¸
t
(i).
The decision on the selling price 1
t
(i) determines the amount to produce ¸
t
(i). This can be
obtained with the production technology ¸
t
(i) = ,(.
t
. :
o
t
(i)) by employing some certain units
of labor :
o
t
(i) provided the state of technology .
t
. How do we calculate the (market-clearing)
real wage with this inelastic labor demand? It can be given by the labor supply function at
the level of labor demanded by the …rms. For this reason, we need to drop the inelastic labor
supply assumption. Thus, the optimizing program for a …rm that sets the price optimally
in period t is
`cr
1t(i)
1
t
1

)=0
,
)
_
_
1
t+j
(i)
1
t+j
_
10
¸
t+)
n
t+)
:
o
t+)
(i)
_
.
whose …rst order condition is
(1 o)
_
1t(i)
1t
_
0
¸
t
n
t
J:
o
t
(i)

t
(i)

t
(i)
J1
t
(i)
= 0. (2)
Notice that the partial derivatives that appear in the second term of (2) are the inverse of
the marginal product of labor (
0a
d
t
(i)
0jt(i)
=
1
)
n
d
t
(i)
), and the marginal response of the amount of
output produced by the i …rm to a change in her selling price which using (1) results as
follows

t
(i)
J1
t
(i)
= o
_
1t(i)
1t
_
01
¸
t
1
t
= o
¸
t
(i)
1t(i)
1t
1
1
t
= o
¸
t
(i)
1
t
(i)
. (3)
Let us denote with ·
t
(i) the real marginal cost for the i …rm computed as the ratio between
the real wage and the marginal product of labor
16
·
t
(i) =
n
t
,
a
d
t
(i)
. (4)
Using (3) and (4), we can simplify terms of the …rst order condition (2) in order to reach
1
t
(i) =
o
o 1
1
t
·
t
(i). (5)
16
Total real cost can be written as TC
|
(i) = n
|
:
|
(i). The real marginal cost is therefore
JTct(I)
J¸t(I)
=
n
|
Jnt(I)
J¸t(I)
=
ut
}
n
d
t
(i)
.
41
which implies that the optimal price is set at a constant mark-up,
0
01
, over the nominal
marginal cost.
Following Calvo (1983), we introduce nominal rigidities on price setting by assuming that
…rms have a chance to price optimally only when receiving a market signal that comes up
with a constant probability 1 j. By contrast, there is a probability j that the price cannot
be changed. The Calvo pricing behavior gives rise to the following Dixit-Stiglitz aggregate
price level
17
1
t
=
_
(1 j) [1
t
(i)]
10
+ j [1
t1
]
10
_
1¸(10)
. (6)
where 1
t
(i) is the optimal selling price during period t.
With staggered prices and …xed probabilities, the (conditional) …rst order equation for
the selling price (2) derived above changes to
(1 o) 1
t
1

)=0
,
)
j
)
_
1t(i)
1
t+j
_
0
¸
t+)
+ o1
t
1

)=0
,
)
j
)
n
t+)
J:
o
t+)
(i)

t+)
(i)

t+)
(i)
J1
t
(i)
= 0. (2’)
which can be rearranged to be solved out for 1
t
(i) as follows
1
t
(i) =
o
o 1
_
1
t

1
)=0
,
)
j
)
·
t+)
(i) (1
t+)
)
0
¸
t+)
1
t

1
)=0
,
)
j
)
(1
t+)
)
01
¸
t+)
_
. (7)
After loglinearizing, the optimal price given by equation (7) that conveys Calvo staggered
pricing is approximated by the linear expression
log 1
t
(i) = (1 ,j) 1
t
1

)=0
,
)
j
)
_
log 1
t+)
+
´
·
t+)
(i)
_
. (8)
where …rm-speci…c variables represent …gures obtained under optimal price setting. The
resulting expression implies that the log of the optimal price set depends positively on the
expected future evolution of both the log of the aggregate price level and the log of the
…rm-speci…c real marginal cost. The rate of growth of one variable over one unit of time can
17
If we aggregate prices by the period when the price was set, the Dixit-Stiglitz aggregate price level yields
1
|
=
_
1

¸=0
(1 j)j
¸
[1

(i)]
10
_ 1
1
,
in which (1j)j
¸
is the fraction of households that set a new a price , periods ago. Note that for the lagged
value of the price level
[1
|1
]
10
=
1

¸=0
(1 j)j
¸
[1
|1¸
(i)]
10
Inserting the value of [1
|1
]
10
from the second expression into the …rst one leads to equation (6).
42
be computed using the …rst di¤erence on its natural logaritmth (for example, given a time
variable r
t
its growth rate in period t can be obtained as
ata
t1
at
= log(r
t
) log(r
t1
)).
18
therefore, the rate of in‡ation observed in period t is :
t
= log 1
t
log 1
t1
, and future values
of the log of price level can be obtained as log 1
t+)
= log 1
t
+

I
I=1
:
t+I
. Taking into account
the last expression for log 1
t+)
in (8), we can derive (after some algebra) an expression for
the relative price
log 1
t
(i) log 1
t
= (1 ,j) 1
t
1

)=0
,
)
j
)
´
·
t+)
(i) + 1
t
1

)=1
,
)
j
)
:
t+)
. (9)
The de…nition of the Dixit-Stiglitz aggregate price level provided above can be log-
linearized to yield
log 1
t
= (1 j) log 1
t
(i) + j log 1
t1
.
where considering the de…nition of the rate of in‡ation, :
t
= log 1
t
log 1
t1
, leads to
log 1
t
log 1
t
(i) =
1 j
j
:
t
. (10)
Combining equations (8) and (9) results in the following formulation for in‡ation quarter-
to-quarter changes
:
t
:
cc
= , (1
t
:
t+1
:
cc
) +
(1 ,j)(1 j)
j
´
·
t
(i) (11)
The in‡ation equation obtained implies that current in‡ation depends upon its expected
value for the next period and the current real marginal cost under optimal pricing. In‡ation
is purely forward looking as there is no lagged in‡ation term in (11). As a consequence,
current in‡ation depends positively on the present and all discounted future real marginal
cost under optimal pricing.
There is a …nal step to get to the New Keynesian Phillips curve. We need to express the
in‡ation equation in terms of aggregate variables. Following Sbordone (2002) we can …nd
a linear relationship between the optimal-price real marginal cost
´
·
t
(i) and the aggregate
real marginal cost
´
·
t
for our Cobb-Douglas production technology.
19
Substituting it out in
equation (11) and, doing some algebra, yields
:
t
:
cc
= , (1
t
:
t+1
:
cc
) +
(1 ,j)(1 j)
j
_
1 +
0c
1c
_
´
·
t
. (12)
18
The proof is straightforward in continuous time:
J log rt
J|
=
J log rt
Jrt
Jrt
J|
=
1
Jrt
Jrt
J|
.
19
Concretely,
´
c
|+¸
(i) =
´
c
|+¸

0o
1o
_
q
1q
¬
|

¸
|=1
¬
|+|
_
.
43
For practical purposes, it would be even more convenient to have the Phillips curve relating
in‡ation and some cyclical measure output. To achieve this, we must …nd the link between
the aggregate real marginal cost and the output gap. The output gap is commonly de…ned
as the fractional deviation of current output from the ‡exible-price level of output (see
Woodford, 2003, pages 247-249). Denoting ¯ ¸
t
for the output gap in period t, this de…nition
implies ¯ ¸
t
= ´ ¸
t

´
¸
t
where the term
´
¸
t
is called either natural-rate output or potential
output. Natural-rate output is calculated assuming that the economy is free of nominal
rigidities when setting prices and/or wages. In the price setting scheme à la Calvo, this
is the extreme case j = 0.0 in which all producers receive the market signal to adjust the
price optimally. It results in a constant mark-up of prices over the marginal costs and, as
a consequence, we have
´
·
t
= 0.0 and the log of the marginal product of labor coincides
with the real wage every period. Meanwhile, (optimizing) households supply the amount of
labor services that makes the marginal rate of substitution between hours and consumption
equal to the real wage (equation 11 of the previous chapter) Therefore, potential output
‡uctuations are driven by this equation presented in the ‡exible-price competitive economy
of the previous chapter and rewritten here
´
¸
t
=
1 c
c + i + /
1
(1 c)

t
+ (1 + i) .
t
) (13)
A positive relationship may be expected since an increase in current output about potential
output will imply more labor employed in the production function and a lower marginal
productivity. In turn, marginal costs would rise and price in‡ation will move upwards. Let
us check this expected sign next.
The log-linearized equations for the economy-wide real marginal cost and the market-
clearing real wage are
´
·
t
= ´ n
t
´ ¸
t
+ ´ :
t
. (14)
´ n
t
= i´ :
t
·
t
+ /
1
´ ¸
t
. (15)
where (15) can be obtained by taking logs on both sides of the labor supply curve derived from
the households’ optimizing behavior (see equation (11) from previous chapter). Combining
(14) and (15), it is obtained
´
·
t
= (1 + i)´ :
t
·
t
(1 + /
1
)´ ¸
t
. (16)
The Cobb-Douglas production technology featuring a technology shock, .
t
, can be loglin-
earized to yield
´ ¸
t
= (1 c) .
t
+ (1 c) ´ :
t
. (17)
44
Inserting the value of log-‡uctuations of labor implied by (17) into (16), we …nd (after
rearranging terms)
´
·
t
=
c + i + /
1
(1 c)
1 c
´ ¸
t
(1 + i).
t
·
t
. (18)
Fluctuations on potential output given in (equation 14 from previous chapter) allows us to
rewrite (18) as follows
´
·
t
=
c + i + /
1
(1 c)
1 c
´ ¸
t

c + i + /
1
(1 c)
1 c
´
¸
t
.
where inserting the de…nition of the output gap, ¯ ¸
t
= ´ ¸
t

´
¸
t
, yields
´
·
t
=
c + i + /
1
(1 c)
1 c
¯ ¸
t
. (19)
Using (19) in the in‡ation equation (12) leads to the so-called New Keynesian Phillips curve
:
t
:
cc
= , (1
t
:
t+1
:
cc
) + c¯ ¸
t
. (20)
with c =
(1oj)(1j)
j(1+

1
)
c+i+b
1
(1c)
1c
. The New Keynesian Phillips curve (20) will be used in the
upcoming chapter for our business cycle and monetary policy analysis.
6.2 The output gap in the IS curve and the Taylor monetary policy
rule
Let us write the optimizing IS curve (see equation 17a from the previous chapter) in terms
of the output gap. Thus, using the de…nition ¯ ¸
t
= ´ ¸
t

´
¸
t
. we have
¯ ¸
t
= 1
t
¯ ¸
t+1
/(1
t
1
t
:
t+1
:
cc
) + /·
t
(
´
¸
t
1
t
´
¸
t+1
).
where the process determining potential output ‡uctuations,
´
¸
t
=
1c
c+i+b
1
(1c)

t
+ (1 + i) .
t
),
can be inserted to obtain the IS curve
20
¯ ¸
t
= 1
t
¯ ¸
t+1
/(1
t
1
t
:
t+1
:
cc
) + c·
t
d.
t
. (21)
with c = /
1c
c+i+b
1
(1c)
and d =
(1c)(1+i)(1j)
c+i+b
1
(1c)
. It is important to realize that since c 0
a positive demand-side shock, ·
t
, always gives rise to a positive output gap. By contrast, a
positive supply-side shock .
t
always gives rise to a negative output gap. If the central bank
20
It was also assumed that the technology shock follows the AR(1) process .
|
= j.
|1
+i
|
with i
|
being
white noise.
45
wishes to stabilize both in‡ation and the output gap in a systematic way, the movements of
the nominal interest rate could be governed by the Taylor-type policy rule
1
t
1
cc
= j
1
(:
t
:
cc
) + j
2
¯ ¸
t
(22)
The three-equation system (20), (21), and (22) gives solution paths for the three endogenous
variables :
t
, ¯ ¸
t
, and 1
t
.
PROBLEMS
6.1. What is the steady-state value for
1

t
1t
in the sticky-price model of the text? Hint:
take the de…nition of the Dixit-Stiglitz price level in steady state.
6.2. Use equation (2’) to …nd the steady-state value of the real marginal cost
&
)n
with
staggered prices à la Calvo. Since the real marginal cost is the inverse of the monopolistic
competition mark-up of prices over marginal costs.
i) Is there a constant monopolistic competition mark-up term in steady state?
ii) What are the determinants of it?
6.3. Represent the New Keynesian Phillips Curve (20) in the (:. ¯ ¸) diagram as the AS
curve of the economy together with the AD curve of the economy implied by (21) and (22).
i) How is the position of the AS curve a¤ected by an increase in the slope coe¢cient on
the output gap, c?
ii) How is the position of the AS curve a¤ected by a decrease in expected future in‡ation
1
t
:
t+1
?
iii) How is the position of the AD curve a¤ected by a positive technology shock .
t
?
iv) How is the AS-AD equilibrium a¤ected by a positive technology shock, .
t
?
v) How is the AS-AD equilibrium a¤ected by a positive preference shock, ·
t
?
6.4. (For algebra lovers only). Find the New Keynesian Phillips curve if the following
stochastic indexation rule is applied for adjusting the non-optimal prices
1
t
(i) = (1 + :
cc
+ .
t
) 1
t1
(i).
where the stochastic element is an AR(1) .
t
= j.
t1
+ c
t
and c
t
`
_
0. o
2
ct
_
.
46
7 Business Cycle and Monetary Policy Analysis in the
New Keynesian model
Our New Keynesian economy is represented by these three linear equations
¯ ¸
t
= 1
t
¯ ¸
t+1
/(1
t
1
t
:
t+1
:
cc
) + c·
t
d.
t
. (AD)
:
t
:
cc
= , (1
t
:
t+1
:
cc
) + c¯ ¸
t
. (AS)
1
t
1
cc
= j
1
(:
t
:
cc
) + j
2
¯ ¸
t
+ c
t
. (MPR)
that determine dynamic behavior of the three endogenous variables ´ ¸
t
, :
t
, and 1
t
. The
Aggregate Demand equation (AD) is the optimizing IS curve (20), the Aggregate Supply
equation (AS) is the New Keynesian Phillips Curve (19), and the nominal interest rate
follows a Monetary Policy Rule (MPR) à la Taylor (1993) which incorporates the novelty of
a white-noise shock, c
t
.
7.1 Business Cycle Analysis
This sub-section is intended to be worked out by the student. Hence, some problems are
proposed
21
* 7.1. Let one economy be described by the (AD)-(AS)-(MPR) model under the following
parameter calibration , = 0.995, o = 2,
c
ss
j
ss
= 0.7, j = 0.75, o = 5.0, i = 4.0, c = 0.36,
j = 0.95, j
1
= 1.5, and j
2
= 0.5. Recall that the technology shock follows an AR(1) process
.
t
= j.
t1
+
t
with a coe¢cient of correlation j = 0.95 and
t
being a white-noise shock.
The standard deviations of the shocks are o
u
= 0.015. o
c
= 0.003, and o
.
= 0.007.
i) Using one computer, take random draws from the Normal distribution of probability
and simulate the model for one thousand periods (quarters).
ii) Calculate the standard deviations of the three variables of the model and coe¢cients
of correlation among them.
iii) Repeat the exercise for at least twenty …ve times and obtain the average standard
deviations and coe¢cients of correlation.
7.2. Find the MSV solution for the New Keynesian optimizing economy (AD)-(AS)-
(MPR) considering that .
t
follows an AR(1) process and both ·
t
and c
t
are white noise.
(Try to do it by hand and check the correct results on the computer).
21
Problems with an asterisk symbol "*" should be solved using MatLab an a computer.
47
i) Discuss the impact of a positive demand-side shock ·
t
on ¯ ¸
t
, :
t
, and 1
t
. Represent
this shock in the (:. ¯ ¸) diagram.
ii) Discuss the impact of a positive technology shock .
t
on ¯ ¸
t
, :
t
, and 1
t
. Represent this
shock in the (:. ¯ ¸) diagram.
iii) Discuss the impact of a positive interest-rate shock c
t
on ¯ ¸
t
, :
t
, and 1
t
. Represent
this shock in the (:. ¯ ¸) diagram.
7.3. For the calibrated (AD)-(AS)-(MPR) economy described in problem 7.1,
i) Calculate the standard deviations of in‡ation from the MSV solution obtained in 7.2.
ii) Compare the …gure obtained with the one given by the simulation exercise of problem
7.1.
iii) Calculate the coe¢cient of correlation between in‡ation and output from the MSV
solution obtained in 7.2.
iv) Compare the …gure obtained with the one given by the simulation exercise of problem
7.1.
* 7.4. An economy with a lower coe¢cient of relative risk aversion o.
There is an (AD)-(AS)-(MPR) optimizing economy with the same calibrated parameters
as problem 7.1 except for a higher elasticity of intertemporal substitution / = 0.5 due to a
lower coe¢cient of relative risk aversion o.
i) Discuss the e¤ects on the coe¢cients of the MSV solution.
ii) Calculate the standard deviations and compare values with the case / = 0.35.
iii) Calculate the coe¢cients of correlation and compare values with the case / = 0.35.
* 7.5. An economy with in‡ation more sensitive to output ‡uctuations.
There is an (AD)-(AS)-(MPR) optimizing economy with the same calibrated parameters
as problem 7.2 except for a higher coe¢cient of dependence of in‡ation on output c = 0.2.
i) Discuss the e¤ects on the coe¢cients of the MSV solution.
ii) Calculate the standard deviations and compare values with the case c = 0.15.
iii) Calculate the coe¢cients of correlation and compare values with the case c = 0.15.
7.6. Technology shocks and the New Keynesian model.
In a technology-driven business cycle, the economy evolves in accordance with the (AD)-
(AS)-(MPR) model New Keynesian model with neuther preference shocks (·
t
= 0.0) nor
interest-rate shocks (c
t
= 0.0). Therefore, the only exogenous variable is the AR(1) process
.
t
that provides the inertial evolution of technology, .
t
= j.
t1
+
t
, where
t
is white noise.
48
i) Find the undetermined coe¢cients (c
1
, c
2
, c
3
) for the following MSV solution of the
New Keynesian model presented above
¯ ¸
t
= c
1
.
t
.
:
t
:
cc
= c
2
.
t
.
1
t
1
cc
= c
3
.
t
.
ii) Using the utility function and production function speci…ed in the notes, obtain the
numerical values of c
1
, c
2
and c
3
for this calibration of parameters , = 0.995, o = 2,
c
ss
j
ss
= 0.7, j = 0.66, o = 5.0, i = 4.0, c = 0.36, j = 0.95, j
1
= 1.5, and j
2
= 0.5.
iii) If 1
cc
= 0.01, calculate the (annualized) value of the nominal interest rate that
responds to a one-time 1% technology shock at the quarter of the shock. Does the central
bank raise or lower the nominal interest rate after this technology shock? If :
cc
= 0.005,
calculate the (annualized) rate of in‡ation at the quarter of the 1% technology shock.
iv) Recalling
´
¸
t
=
(1c)(1+i)
c+i+b
1
(1c)
.
t
, …nd the immediate reaction of potential output, current
output, and the output gap.
7.2 Monetary Policy Analysis
A substantial part of monetary policy research in recent years has been devoted to the design
of monetary policy rules (MPR). Particularly, the motivation has always been to …nd some
activist rule that, by adjusting the policy instrument in response to the actual state of the
economy, is able to partially or totally achieve policy targets. Such policy targets are usually
de…ned as minimizing deviations of the target variables (in‡ation, output,...) from their
long-run values.
22
A MPR can be classi…ed as a targeting rule or as an instrument rule. These two cate-
gories have been proposed by Lars Svensson (see, for example, Svensson, 2002). Targeting
rules are designed by presenting a central bank’s loss function whose arguments are the
monetary policy targets. The loss function is then minimized subject to aggregate demand
and aggregate supply equations that constitute the model of the economy. An implicit re-
action function, a MPR, might be written as the optimal response of the monetary policy
instrument (typically the nominal interest rate) to current or/and expected values of state
22
The impossibility of attaining signi…cant long-run e¤ects on output (or economic growth) has been
widely recognized by researchers. Besides, this monetary policy would generate the Barro-Gordon in‡ation
bias e¤ect. Consequently, output growth is ruled out from the monetary policy targets.
49
variables. Two in‡uential papers on targeting rules are Clarida, Galí, and Gertler (1999),
and Svensson (1999).
Other authors prefer to propose simple rules that are robust to model settings, the so-
called instrument rules.
23
They argue that optimal control can be misleading due to its
strict dependence on the de…nition and calibration of the model. In addition, the instrument
reaction function implicitly derived from optimal control rules becomes convenient for policy
making only within small-size models. In large models there are numerous state variables
which are not directly observable in the real world. Consequently, the implementation of
the MPR may have high information costs and is subject to many possible computational
mistakes.
Instrument rules
We already know that a Taylor rule is a simple MPR that adjusts the nominal interest
rate depending upon the current values of the in‡ation deviation from steady state and the
output gap
1
t
1
cc
= j
1
(:
t
:
cc
) + j
2
¯ ¸
t
+
t
.
with j
1
1 and j
2
0. It is time now to think about the “best” value for the coe¢cients
j
1
and j
2
. The determination of these …gures correspond to the monetary authority (the
central bank) in accordance with some strategy de…ned in its operational establishment. Let
us assume, in quite a realistic way, that the central bank wishes to stabilize both in‡ation and
the output gap. In other words, the central bank would like to minimize volatility of both
in‡ation and output. A good measure of volatility is provided by the standard deviation.
Therefore, the central bank will set the value of j
1
and j
2
so that the standard deviations of
in‡ation and output are within some prede…ned desired range. Let us see it with a practical
example:
* 7.6. One economy is described by the (AD)-(AS)-(MPR) model under the calibration
described in problem 7.1. The monetary authority has to decide between one of these four
pairs for the design of the Taylor-style MPR:
a) j
1
= 1.5 and j
2
= 0.0.
b) j
1
= 1.5 and j
2
= 0.25.
c) j
1
= 1.5 and j
2
= 0.50.
23
John Taylor and Bennett T. McCallum probably are the most relevant authors on instrument rules.
50
d) j
1
= 1.5 and j
2
= 1.5.
i) What would be the pair selected if the criterion was to minimize the standard deviation
of in‡ation?
ii) What would be the pair selected if the criterion was to minimize the standard deviation
of output?
iii) What would be the pair selected if the criterion was to minimize the weighted sum
composed of one half of the in‡ation standard deviation and one half of the output gap?
iv) What would be the pair selected if the criterion was to minimize the weighted sum
composed of one third of the in‡ation standard deviation plus one third of the standard
deviation of the output gap plus one third of the standard deviation of the nominal interest
rate?
Now two more problems to discuss money-growth instrument rules
7.7. Suppose that the central bank of one economy wants to implement the Taylor MPR
based on current output ‡uctuations 1
t
1
cc
= j
1
(:
t
:
cc
) +j
2
´ ¸
t
. with j
1
1 and j
2
0
but it has no control on the nominal interest rate. By contrast the central bank has full
control on the rate of money growth of the economy, de…ned as j
t
= log `
t
log `
t1
.
The optimizing money demand (LM) function of this economy is well approximated by
the semi log-linear expression
log `
t
log 1
t
= ¸
1
´ ¸
t
¸
2
(1
t
1
cc
) ¸
3
·
t
. (LM)
where ¸
1
=
o
¸
, ¸
2
=
1
¸1
ss
, and ¸
3
=
1
¸
, and ·
t
is the white-noise consumption preference
shock. Moreover, the AD and AS curve correspond respectively to the optimizing IS curve
and the New Keynesian Phillips curve appearing at the beginning of this chapter.
i) Could you design a monetary policy rule with money growth j
t
= log `
t
log `
t1
as the instrument which maintains the same stabilizing goals as the Taylor rule?
ii) Discuss the rule.
* 7.8. Build a MSV conjecture form for the AD-AS-LM optimizing model with the
following money-growth activist MPR
j
t
= o
1
:
t
o
2
¯ ¸
t
.
where j
t
= log `
t
log `
t1
and o
1
,o
2
0.0. The model must include the (LM) curve in
terms of the output gap
log `
t
log 1
t
= ¹
1
¯ ¸
t
¹
2
(1
t
1
cc
) + ¹
3
·
t
+ ¹
4
.
t
.
51
with ¹
1
=
o
¸
, ¹
2
=
1
¸1
ss
, ¹
3
=
(1c)(o1)
¸(c+i+b
1
(1c))
, and ¹
4
=
o(1c)(1+i)
¸(c+i+b
1
(1c))
. How many state
variables do we need to introduce? Solve the model with the MatLab routine taking the
previously used calibration for structural parameters of the model, 1
cc
= 0.01 in the (LM)
curve, and o
1
= 1.5 and o
2
= 0.5 in the money-growth policy rule. Comment on the results.
Targeting rules
A targeting rule involves a central-bank optimizing program with a particular objective
function. Typically, there is a loss function to be minimized whose arguments are the volatil-
ities of in‡ation, the output gap, the nominal interest rate, and others. Two approaches can
be found in the literature. First, the stabilizing approach in which a generic objective func-
tion collects the volatilities of the central bank target variables (see Svensson, 2003, or Levin
and Williams, 2003). Secondly, the welfare-theoretic approach in which the central bank
objective function is based on an second-order approximation of the households’ utility func-
tion (see Erceg et al., 2000, or, more extensively, Woodford, 2003). In this course we will
use a welfare-theoretic targeting rule. For the utility function speci…ed in the second section
of these notes, the intertemporal loss function of the central bank must approximate this
second-order functional form
1
t
= 1
t
1

)=0
,
)
_
:
2
t+)
+ `¯ ¸
2
t+)
_
.
where ` =
(1oj)(1j)
0j(
1+
1
)
c+i+b
1
(1c)
1c
represents the relative weight of the volatility of the output
gap in the loss function.
24
This is a ‡exible in‡ation-targeting loss function. The central-
bank optimal control program can be written as
`i: 1
t
= 1
t
1

)=0
,
)
_
:
2
t+)
+ `¯ ¸
2
t
_
subject to :
t+)
:
cc
= , (1
t+)
:
t+1+)
:
cc
) + c¯ ¸
t+)
,o: , = 0. 1. ...
Taking the …rst derivatives with respect to :
t
and ¯ ¸
t
results in
2 (:
t
:
cc
) + ,
t
= 0. (:
)cc
t
)
2`¯ ¸
t
c,
t
= 0. (¯ ¸
)cc
t
)
where ,
t
is the Lagrange multiplier attached to the AS curve in period t. Eliminating
precisely ,
t
from the pair of equations yields the optimal policy
:
t
:
cc
=
`
c
¯ ¸
t
=
1
o
¯ ¸
t
. (1)
24
See Woodford (2003, chapter 8) for the proof.
52
This expression is often called the “leaning against the wind” policy. If output is above its
potential level, ¯ ¸
t
0, the central bank should respond by implementing some policy to
make in‡ation fall below its steady state. This would typically be a contractionary policy
on aggregate demand which would imply an increase in then nominal interest rate. Problem
7.9 below calculates the reaction function for the nominal interest rate with the policy rule
(1).
So far, the targeting rule is obtained only for period t. In the next period the central
bank would reoptimize by solving again its optimal control program. This policy is often
denominated discretionary. Alternatively, the central bank could establish a monetary policy
behavior once and for all the periods. This is denominated a targeting rule under commit-
ment. Clarida et al. (1999) and Woodford (2003), chapter 7, show that a targeting rule is
more e¢cient under commitment than under discretion.
The commitment to a targeting rule means that in period t the central bank calculates
the …rst order conditions with respect to :
t+)
and ´ ¸
t+)
for , = 0. 1. 2. .... 1. For the current
period we already computed the pair of conditions :
)cc
t
and ¯ ¸
)cc
t
above. Regarding all the
future periods (, = 1. 2. .... 1), it is obtained the pair
2 (:
t+)
:
cc
) ,
t+)1
+ ,
t+)
= 0. (:
)cc
t+)
)
2`¯ ¸
t+)
c,
t+)
= 0. (¯ ¸
)cc
t+)
)
which eliminating the Lagrange multiplier implies
:
t+)
:
cc
=
`
c
(¯ ¸
t+)
¯ ¸
t+)1
) =
1
o
(¯ ¸
t+)
¯ ¸
t+)1
). (2)
Now the countercyclical reaction of in‡ation responds to the change in the output gap.
Woodford (2003) argues that the commitment for the implementation of (2) in all the periods
is superior to the discretionary rule (1) for each period. In other words, it results in a lower
unconditional expectation of the loss function value.
7.9. i) Find the MSV solution for the following model including a targeting MPR
¯ ¸
t
= 1
t
¯ ¸
t+1
/(1
t
1
t
:
t+1
:
cc
) + c·
t
d.
t
. (AD)
:
t
:
cc
= , (1
t
:
t+1
:
cc
) + c¯ ¸
t
. (AS)
:
t
:
cc
=
1
o
¯ ¸
t
(TR)
where in the (AS) curve there is both a technology shock .
t
obtained from the AR(1) process
.
t
= j.
t1
+
t
and ·
t
as the white-noise demand shock.
53
ii) Check the signs on the optimal response of the nominal interest rate when there is a
positive demand shock ·
t
or a positive technology shock .
t
.
* 7.10. The economy of problem 7.9 has been calibrated at the following values of their
parameters o = 2,
c
ss
j
ss
= 0.70, , = 0.995, j = 0.75, o = 5.0, i = 4.0, c = 0.36, and j = 0.95.
The standard deviations of the shocks are o
u
= 0.015, and o
.
= 0.006.
i) Simulate the economy for one thousand periods.
ii) Repeat the exercise at least twenty …ve times. Calculate the average standard devi-
ations of in‡ation, output, and the nominal interest rate (recall that ¯ ¸
t
= ´ ¸
t

´
¸
t
and
´
¸
t
is
exogenous as indicated in equation 12 of chapter 6).
iii) Calculate the coe¢cients of correlation between the three variables. Discuss the
results on empirical grounds.
iv) Calculate the standard deviations of in‡ation and output if the optimal monetary
policy rule had a larger weight on stabilizing the output gap because o = 4.0.
* 7.11. i) Using MatLab on a computer, …nd the MSV solution for the following model
including a targeting MPR under previous commitment (take the calibration of parameters
described in 7.10)
¯ ¸
t
= 1
t
¯ ¸
t+1
/(1
t
1
t
:
t+1
:
cc
) + c·
t
d.
t
. (AD)
:
t
:
cc
= , (1
t
:
t+1
:
cc
) + c¯ ¸
t
. (AS)
:
t
:
cc
=
1
o
(¯ ¸
t
¯ ¸
t1
) (TR)
ii) Obtain the optimal response of the nominal interest rate when there is a positive unit
demand shock (·
t
= 1.0).
iii) Obtain the optimal response of the nominal interest rate when there is a positive unit
technology shock (.
t
= 1.0).
iv) How do these responses change if the relative weight on stabilizing output in the loss
function ` is higher?.
* 7.12. The economy of problem 7.11 (with commitment to a targeting rule) has the
calibration of parameters described in 7.10.
i) Compare the standard deviations of in‡ation, output, and the output gap in both
economies.
54
ii) Calculate the coe¢cients of correlation between in‡ation, output, and the nominal
interest rate. Compare the numbers with the ones obtained with a discretionary targeting
rule. Which ones do better match the data?
iii) Calculate the unexpected loss function value in both economies and compare them.
Which targeting rule is more e¢cient?
* 7.13. Let us introduce a white-noise in‡ation shock, t
t
, in the AS curve
:
t
:
cc
= , (1
t
:
t+1
:
cc
) + c¯ ¸
t
+ t
t
,
which can be driven, for example, by an innovation in the price indexation rule apply by the
fraction of …rms that set non-optimal prices (see Casares, 2007b).
i) Using the calibration of parameteres, o = 2,
c
ss
j
ss
= 0.70, , = 0.995, j = 0.75, o = 5.0,
i = 4.0, c = 0.36, j = 0.95, compare the reaction function of the nominal interest with
a targeting rule under commitment, :
t
:
cc
=
1
0
(¯ ¸
t
¯ ¸
t1
), with that under discretion,
:
t
:
cc
=
1
0
¯ ¸
t
.
ii) Simulate the model for a su¢cient number of times with the innovation volatilities
o
u
= 0.015. o
t
= 0.004, and o
.
= 0.007, and compare standard deviations for in‡ation, the
output gap, and the nominal interest rate with both targeting rules.
iii) Assuming that the mean of the variances of the target variables provide a good aprox-
imation to their true variances, which targeting rule does better in terms of the unconditional
expectation of the welfare-theoretic loss function?
55
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