Orphan Ides 1990

Chapter 6
MONEY, INFLATION AND GROWTH
ATHANASIOS ORPHANIDES and ROBERT M. SOLOW*

Massachusetts Institute of Technology
Contents
0. Introduction 224
0.1. Prior beliefs about inflation 225
0.2. Related questions 226
0.3. Evidence 226
0.4. The role of money in the real economy 227
0.5. The origins of the money and growth literature 228
1. The Tobin effect 229
1.1. The neoclassical model 230
1.2. On stability and uniqueness 233
1.3. The Keynes-Wicksell model 234
2. Money in the utility and production function 236
2.1. The Sidrauski model 236
2.2. Variations of the Sidrauski model 239
3. The Tobin effect and the Fisher relation 241
3.1. The two-period OLG model with money 242
3.2. Family disconnectedness with infinite horizons 246
4. Cash in advance and transactions demand 251
4.1. A "shopping costs" model 251
4.2. Cash in advance for consumption and investment purchases 254
4.3. A digression to inside money 256
4.4. The Tobin effect in a CIA model without capital 257
5. Concluding remarks 257
References 259
*We thank Frank Hahn and Michael Woodford for helpful comments.
Handbook of Monetary Economics, Volume 1, Edited by B.M. Friedman and F.H. Hahn
© Elsevier Science Publishers B.V., 1990
224 A. Orphanides and R.M. Solow
O. Introduction
"My main conclusion is that equally plausible models yield fundamentally

different results", wrote Jerome Stein in the introduction of his 1970 survey of
monetary growth theory. Two decades later all we have is more reasons for
reaching the same conclusion.
Is it possible to affect capital accumulation and output by actions that merely
change the rate of growth of the stock of nominal money? If there are such
effects, will they be permanent, affecting steady-state outcomes, or merely
transitory during the transition to the same (real) steady state? The question
• 1
regarding the superneutrallty of money is concerned with the effects of money
growth on any real variables in the economy but the possible effects on capital,
output and welfare are of greatest interest•
The modern literature really begins with Tobin, who asked the question that
has mainly preoccupied the literature ever since 1965. Different long-run rates
of growth of the money supply will certainly be reflected eventually in different
rates of inflation; but will there be any real effects in the long run? Tobin
studied this ("superneutrality") question in a simple "descriptive" model with
aggregate saving depending only on current income, and seigniorage distribut-
ed in such a way as to preclude any distributional effects. He found that faster
money growth is associated with higher capital stock and output per person in
the steady state• Faster inflation leads savers to shift their portfolios in favor of
real capital•
Sidrauski soon embedded the same problem in a model of an immortal
consumer maximizing an additive discounted lifetime utility. Then, the steady-
state real interest rate can be the utility-based discount rate. If the marginal
product of capital depends only on the capital-labor ratio, then capital per
person is tied down asymptotically, independently of money growth or infla-
tion. In the Sidrauski model superneutrality prevails.
The later literature is mostly variations on this theme• If the production
function is such that the marginal product of capital depends on other things
besides the capital intensity of production, then superneutrality can fail. If
agents differ in essential ways (including date of birth), constancy of consump-
tion per head is not the same thing as constant consumption during a lifetime;
again superneutrality may fail. For the same reason, the distribution of
1A model is said to exhibit m o n e y neutrality if a change in the level of nominal m o n e y does not
affect real variables. Superneutrality applies the same concept to changes in the rate o f growth of
nominal money. In this survey we are only concerned with the superneutrality of m o n e y and, as a
result, we follow much of the literature in dropping the prefix " s u p e r " from references to the word
superneutral.
Ch. 6: Money, Inflation and Growth 225
seigniorage proceeds can disturb superneutrality: the aggregate saving rate

depends on the stage of the life cycle in which (anticipated) benefits from
seigniorage are received.
The main lessons were thus already implicit in the work of Tobin and
Sidrauski. For those who can bring themselves to accept the single-consumer,
infinite-horizon, maximization model as a reasonable approximation to
economic life, superneutrality is a defensible presumption. All others have to
be ready for a different outcome.
This is the basic message we attempt to convey in the review of the monetary
growth theory that follows. In Section 1 we develop the neoclassical Tobin
model and the parallel non-optimizing, non-neoclassical theory that was de-
veloped and became known as the Keynes-Wicksell model. In Section 2 we
examine the Sidrauski model illustrating the central neutrality result and then
show some of its variations in which neutrality with respect to output fails even
though the real interest rate is not affected by inflation (in the long run, of
course). The Fisher relation is closely examined in Section 3 which concen-
trates on deviations from the one infinitely lived family models of Section 2.
The exact function of money and the sensitivity of the long-run inflation-
growth relation to different assumptions about the reasons why money is held
are examined in Section 4.
Before embarking on the main theme, we close the introduction by briefly
going over some themes that provide a background for what follows.
0.1. Prior beliefs about inflation
Is inflation "good" or " b a d " ? All three possibilities serve as reasonable

priors:
(a) Inflation has no effect on any real variables. How could little green (or
other colored) pieces of paper make a real difference anyway?
(b) Tobin's portfolio shift effect: non-interest-bearing money is held as an
asset, so if we can induce people to hold less of it they will keep their savings in
more productive forms. Hence, some inflation increases capital per man and
therefore output per man along the growth path (though not the rate of real
growth, of course).
(c) Inflation is bad, period. Whatever the function of money is, it becomes
harder to sastisfy in the presence of inflation, especially rapid inflation. This is
an interesting prior since it is the one held by virtually every policy-maker.
Furthermore, the reasons this view is held have nothing to do with the money
and growth literature. We know of no study of hyperinflations that mentions
the Tobin effect! If the money and growth literature is relevant to anything,
this must be where it fits in. (Of course, there never was any implication that
the Tobin effect would outweigh the disorganizing consequences of very rapid
inflation.)
0.2. Related questions
To the extent that money growth may affect some real variables, is there an
optimal rate of growth of money (and therefore inflation) that maximizes
welfare? Indeed, whether inflation is positively or negatively related to output
in the long run is beside the point if our objective is to maximize not output but
something else. The chapter by Woodford on the optimum quantity of money
in this H a n d b o o k (Chapter 20) deals with this issues in more detail, but for our
purposes it should be noted that if money is not superneutral and an optimal
rate of growth does exist, the optimal rate may not be the one maximizing
output. Thus, the money and growth question is intimately connected with the
optimal rate of inflation question.
Does the Fisher relation hold? An answer to this is a byproduct of the
money and growth models since the main mechanism for non-neutrality is the
effect of inflation on the real rate of interest. As we make clear in Sections 2
and 3, it is also useful to distinguish between mechanisms that exhibit
non-neutrality while not invalidating the Fisher relation from those that
invalidate the Fisher relation as a means of obtaining non-neutrality.
The money and growth literature is primarily concerned with the question of
whether money is neutral across steady states, but it is important to consider
the other questions as well in order to understand the development of the
literature. Unlike current practice, the same models were sometimes used to
examine the short-run employment effects of money as well as the long-run
output effects (the catchword is "Keynes-Wicksell models"). Currently, the
short-run effects of money are usually analyzed within models that either
ignore the long-run neutrality question or assume it to begin with. Other
chapters in this H a n d b o o k deal explicitly with such short-run models.
0.3. Evidence
Monetary events seem to have effects in the short run. That much seems to be
well established. The Phillips c u r v e - to the extent that it is still considered a
useful device - is exactly about the relation between output and inflation in the
short run. Recently a series of VAR models have been used to illustrate
empirically just this short-run relation. Evidence on the long-run relationships
is by far more difficult to find. Using long time series data for the United
States, Geweke (1986) finds evidence in support of the superneutrality of

money on output. Restricting attention to post war U.S. data, Jun (1988) finds
a strong negative correlation between money and output growth. Fischer
(1983), in a cross-section time-series regression for 53 countries, reports a
negative relationship between inflation and growth. Both the Jun and Fischer
results imply anti-Tobin failure of superneutrality conditional on the identifying
assumption of the money growth being exogenous in the long run. As Jun
makes clear, however, his results may simply be due to a monetary policy rule
which is negatively related to output. Since neither study accounts for supply
side/productivity shocks and the low growth post-oil shock period of coincides
with worldwide high inflation, the results may indeed reflect monetary accom-
modation of these shocks.
Evidence on whether the Fisher relation is satisfied in the long run also
provides information about the long-run neutrality of money. Empirical results
for the United States indicate that the hypothesis that the Fisher relation is
satisfied in the long run is not rejected. Yet, there is little power against the
alternative that inflation has a small effect on the real interest rate [Gali
(1988)].
0.4. The role o f m o n e y in the real economy
In order to make sense out of any theory atempting to examine the possible
effects of changing the level/rate of growth of money on real variables, one
must first explain the very existence of money in the economy. Why are people
willing to hold money and what is its function? Depending on the choice of first
principles given and the exact way in which the underlying relationship
between money and real variables is postulated, we should expect to and do
get different conclusions regarding the effect of money on real variables.
Various assumptions are encountered in the models we examine here. The
following checklist is intended only as a reminder; the fundamental nature of
money is not our business.
• Money is an asset and can be used as a store of wealth. It is held as part of
an individual's portfolio because of its rate of return characteristics.
• Money is an asset that facilitates intergenerational transfers. It is held simply
because it is known that others will be willing to hold it in the future.
• Money is necessary for transactions. Money must be held for some period of
time before a purchase takes place. Either the time it must be held is kept
fixed (the one-period cash-in-advance constraint) or it is an endogenous
decision within a Baumol-Tobin model of money demand.
• Money facilitates transactions. It is a substitute for leisure or real output in
the available "transactions technology".
• Money is a factor of production in much the same way that labor and capital
are. It is an inventory.
• Money is an argument in utility: people derive utility from holding money in
much the same way as they derive utility from consuming real goods.
It is clear that the last three are shortcuts for the deeper reasons that are
given in the first three arguments and unfortunately the results of monetary
growth models are quite sensitive to them. This problem was recognized quite
early in the literature. Dornbusch and Frenkel (1973), for instance, state,
,[C]onflicting or ambiguous results derived from alternative theories are
primarily the reflection of different hypotheses about the functions of money"
(p. 141).
0.5. The origins of the money and growth literature
The basic mechanism used to link money and growth is through the effects of
money on the real interest rate and thereby on capital accumulation. Metzler
(1951) points out that the central bank can affect the real interest rate through
money market operations and concludes:
[B]y purchasing securities, the central bank can reduce the real value of
private wealth, thereby increasing the propensity to save and causing the
system to attain a new equilibrium at a permanently lower interest rate and a
permanently higher rate of capital accumulation (p. 112).
Thus, Metzler, in his attempt to explain why the real interest rates is a
monetary variable, offers the first concrete model in which money can affect
output in the long run. Note, however, that Metzler's monetary effect is
severely limited by the securities that can ultimately be bought by the central
bank through open market operations and is incomplete because he does not
examine the effects of inflation on the interest rate (and does not even
distinguish between a real and a nominal rate). In fact growth-theoretic
concepts are ignored: a "higher rate of capital accumulation" means higher
current real investment, not a higher sustainable growth rate.
Mundell (1963) was the first to propose a connection between anticipated
inflation and the real interest rate. His argument basically concerns the impact
effect of an unanticipated permanent increase in the inflation rate. The impact
effect is a reduction in the real wealth of individuals which increases their real
savings thereby increasing capital and reducing the real interest rate. This,
however, is a short-run effect that cannot be expected to affect the steady-state
rate of interest.
1. The Tobin effect
It was not until Tobin's (1965) exposition that the portfolio mechanism
connecting m o n e y growth and capital formation became clear. 2'3 His model is
based on the one-sector neoclassical growth model of Solow (1956) and Swan
(1956). Output is produced with a linear h o m o g e n e o u s production function so
that real net per capita output, y, is: 4
y : f(k). (1.1)
In the n o n - m o n e t a r y model, capital, k, is the only form of wealth. In the

simplest m o n e t a r y growth model real per capita m o n e y balances, m, are
introduced as an alternative form of wealth. Thus, real wealth kept in the form
of financial assets, a, is:
a = k + m. (1.2)
Tobin's basic intuition that became the central issue of all the subsequent
literature can be simply stated as follows. Given a level of real wealth, the
capital intensity of the e c o n o m y depends on the composition of wealth a m o n g
capital and money. If the return of holding m o n e y as a financial asset is
reduced, the relative composition of assets will shift towards capital, thereby
increasing output. The opportunity cost of holding m o n e y instead of capital is
r + zr, the real rate of return on capital 5 plus inflation, 6 which is the rate of
depreciation of the real value of m o n e y holdings. Therefore, by increasing the
rate of inflation the central bank can shift the composition of financial holdings
towards capital.
Clearly, then, if asset holdings remains constant, an increase in the rate of
inflation would increase equilibrium capital and output. The level of wealth is,
however, an endogenous variable dependent on the saving behavior of the
individual and bound to change with inflation. If saving behavior is such that,
in equilibrium, wealth is decreased by exactly the same amount that real
ZSome of the analysis, however, follows directly from his earlier papers [Tobin (1955, 1961)].
3Other early treatments along the same lines include Johnson (1966, 1967a, 1967b), Sidrauski
(1967b) and Tobin (1968). Stein (1966, 1968) also obtained the Tobin effect, but not in a
neoclassical framework.
4Net output equals gross output minus the linear depreciation of capital. The usual convention of
employing lower-case letters as the per capita counterparts of their aggregate counterparts is
employed.
5In equilibrium r is the marginal product of capital, f'(k).
6We assume perfect foresight and we will therefore make no distinction between expected and
actual inflation. We will return to this assumption when discussing the dynamics of these models.
money holdings are reduced due to the portfolio selection behavior, then
inflation will have no effect on capital intensity; in other words, neutrality will
hold. Therefore, it is the interaction of the portfolio composition effect and
saving behavior that determines the extent of the effect of inflation on capital.
1.1. The neoclassical model
Following the original non-monetary growth model, Tobin assumed that real
private savings are a fixed proportion of real disposable i n c o m e ] Real dispos-
able income is defined to be real output plus the increase in real cash balances
(which in turn is the sum of the real value of s e i g n o r a g e - transferred by the
government to the private s e c t o r - and real capital gains on initial money
holdings). Real investment is then the part of real savings that it not absorbed
by increases in real cash balances. Thus
where P is the price level. Letting 0 and n denote the rate of growth of nominal
money and the rate of growth of labor, (1.3) can be written in per capita terms
as
I~ = s y - (1 - s)(O - rr)m - nk. (1.4)
Since m is real per capita money balances (m = M/PN), it evolves through

time according to
rh = m . ( 0 - 7 r - n ) . (1.5)
In the steady state, 8 7r = 0 - n and the steady-state relation between real

money balances and capital that is implied by the savings behavior is:
0 = sf(k) - (1 - s)nm - nk. (1.6)
It is immediately clear from (1.6) that in this case anything that reduces
equilibrium real money balances in the steady state will result in a higher level
of capital. 9 The model described by (1.3) and (1.4) does not indicate the
7Hadjimichalakis (1971b) examines several variations of the Tobin model that share the
assumption of savings as a fixed proportion of income.
8Dynamics and stability issues are briefly discussed later.
9provided that the usual non-monetary stability condition holds, that is s • f ' ( k ) - n < O.
preferences of owners of wealth regarding the form in which they wish to hold
their wealth. The model can be closed by specifying a money demand
equation 1° capturing the portfolio decision, for instance:
m=~b(r+7 0 -k, ~b'<0, (1.7)
and the steady-state equilibrium level of capital in terms of the rate of money
growth is given by
O= s" f ( k ) - (1 - s)" n . O ( f ' ( k ) + O - n)" k - n" k , (1.8)

so that d k / d O is positive.
The assumption that savings is proportional to income results in the most
unambiguous statement of the Tobin effect. The portfolio equation (1.7), for
example, could be replaced with a quantity theory (or transactions) demand for
money of the form:
m = ~b(r + 7 r ) . y (1.9)
or
m = ~ ( r + 7r)- c ,
without changing the result since y is a monotone function of k and in

equilibrium c increases with y.
The Tobin effect continues to prevail when the fixed savings rate assumption
is replaced with a lifecycle based consumption function which makes consump-
tion a function of wealth:
c=c(a), c'>O. (1.10)
Since, in the steady-state, equilibrium consumption equals net output, if

assets are given by (1.2) and the demand for money by (1.7), then the
steady-state relation between the rate of money growth and output is given by
f ( k ) = c([1 + d ? ( f ' ( k ) + 0 - n ) ] - k ) , (1.11)
and again d k / d O > O, at any stable steady state. 11
~°The implication of (1.7) is that the capital market clears instantaneously, with the price level
adjusting to equate the demand for money with the supply. The alternative would be to
hypothesize slow adjustment of the price level in response to a gap between the right- and
left-hand sides of (1.7). Obviously, this would make no difference in steady states.
HSee Dornbusch and Frenkel (1973) for details on this example.
The Tobin effect, however, is not robust to other seemingly minor modifica-
tions of the model. Even under the original assumption of a fixed savings rate
out of income, differences in the definition of disposable income - to allow for
the services of money balances, for example- could qualitatively change the
result) 2 More importantly, however, the effect may be reversed if the assump-
tion of the constancy of the savings rate is relaxed. While for the growth
models that simply attempt to relate the rate of savings to growth this
assumption may be appropriate, it is totally inappropriate when the interaction
between portfolio choice and savings is important. 13 If, for example, savings is
discouraged by inflation, the result may be reversed. Levhari and Patinkin
(1968) specify the savings rate as a function of the rates of return of the two
assets:
s=s(r,-rr), s1>0, s 2 > 0 , (1.12)
and show that the Tobin effect becomes ambiguous. In the same spirit,
Dornbusch and Frenkel specify:
c = c(a, ~r), cl > 0 , (1.13)
and show that if inflation has a strong positive effect on consumption demand
the Tobin result is reversed.
The most far-reaching criticism, however, was with regard to the exact
function of money in the model. Levhari and Patinkin observed that the role of
money in Tobin's model is not sufficiently explained. To the extent that
Tobin's mechanism was based on portfolio selection and money is an asset that
can be dominated, the model should say why money is held in the first place.
In Tobin's original formulation the highest level of steady-state capital is
achieved when money balances are actually driven to zero. In that case (1.6)
collapses to
0 = s- f(k) - n. I,, (1.14)
which is the non-monetary growth model condition of Solow (1956). Levhari

and Patinkin suggested treating money as either a consumption good or a
production good and showed that, in each case, the Tobin effect does not
obtain unambiguously. They justified their treatment by referring to the
12The starting point was the exchange between Johnson, (1966, 1967a, 1967b) and Tobin (1967).
See also Bailey's (1968) and Marty's (1968) comments on Tobin (1968). More recently the issue
has been examined by Hayakawa (1979), Bandyopadhyay (1982) and Drabicki and Takayama
(1982).
~3Johnson (1966) first raised this criticism.
optimizing behavior of firms and consumers, but without giving any detailed
account of decisions. In Section 2 we turn to models that address this objection
and examine the inflation and growth connection in an explicitly optimizing
framework in which money is assumed to provide consumption or production
services. But first we turn to a brief discussion of the stability properties of the
neoclassical model - an issue which haunted the early literature - and examine
a parallel literature which examines the monetary growth issue in the absence
of the neoclassical assumption of instantaneously clearing markets.
1.2. On stability and uniqueness
The primary objective of this paper is to examine the effects of anticipated

inflation on capital accumulation in the stationary state of the economy. We do
not attempt to analyze the dynamic implications of the models we discuss, even
though they are of at least as great importance. The issue of stability of the
stationary equilibrium, however, cannot be avoided since instability would
render the stationary state analysis irrelevant. Simply, a change in inflation
would not move the economy to the new stationary state, even in the long run.
As was pointed out by Nagatani (1970), Tobin's model exhibits saddlepoint
instabily under the assumption of perfect myopic foresight. At the time this
was considered to be a fatal flaw of the model since it implied that an economy
subject to a perturbation from the steady state - due to an increase in the rate
of money growth, for e x a m p l e - would not reach the new steady state if it
followed the dynamic path that originated at the old equilibrium. As a result,
several modifications of the model were suggested that led to global stability.
Most notably, it was pointed out by Sidrauski (1976b) that if expectations are
formed adaptively and at a sufficiently slow rate, then the model is globally
stable. This, however, did not solve the problem under the presently more
popular assumption of perfect foresight. The active versus passive money
debate [Olivera (1971), Black (1972)] showed that global stability could be
achieved if money is assumed to be passive, with the strange implication that if
money is actively used as a policy instrument the economy is unstable, whereas
if it is not, then the economy is stable. Most other attempts to achieve global
stability, while retaining the perfect foresight assumption, proved fruitless. 14
Sargent and Wallace (1973) provided an alternative way of approaching the
stability issue. They showed that under the perfect foresight assumption the
model should exhibit saddlepoint stability if there is to be a unique path to the
14The exceptions are Hadjimichalakis (1971a, 1971b), Hadjimichalakisand Okuguchi (1979),

Burmeister and Dobell (1970) and Drabicki and Takayama (1984), in which global stability is
achieved by introducing other elements to the model.
steady state. In a model with a unique steady state, like the Tobin model, an
unanticipated perturbation from the steady state should be followed by an
instantaneous "jump" to a path that leads to the new steady state. Unless the
model exhibits saddlepath stability, the "jump" to the new equilibrium path
cannot be uniquely determined. The difference from the earlier interpretation
arises from the fact that perfect foresight is assumed to be global and not
myopic. As a result the saddlepoint stability of the Tobin model is no longer
considered a liability. Note, however, that the attractiveness of the Sargent-
Wallace interpretation is due to the resulting uniqueness of the equilibrium
path. Yet, Black (1974), Brock (1974) and Calvo (1979) show that steady
states could have multiple perfect foresight paths in some models. Calvo
presents examples of cases in which no perfect foresight path is locally unique.
The resolution of the dynamics in those cases has not yet been worked out to
everyone's satisfaction. It involves larger issues than those discussed here.
1.3. The Keynes-Wicksell model
An alternative to the neoclassical monetary models was developed by Rose

(1966) and Stein (1966). 15 These models, inspired by the work of Hahn (1960,
1961), constitute an attempt to reconcile the short-run disequilibrium dynamics
of the economy with long-run growth. In the Keynesian tradition the economy
is not assumed always to be in equilibrium; thus, the models can accommodate
variable employment and underutilization of capital. Two key characteristics
distinguish these models from the neoclassical model:
(a) there are independent investment and savings function 16 - whereas in the
neoclassical market-clearing model investment is identically equal to planned
savings, and
(b) prices are changing if and only if there is market disequilibrium-
whereas in the neoclassical model markets are always in equilibrium regardless
of the level of inflation.
The effect of inflation on steady-state capital in these models turns out to
depend on the particular assumptions that are needed in addition to the ones
specified above in order to close the model. Stein (1971) builds a model in
which the effect depends on whether there is forced saving or saving plans are
realized in the steady state. This is partly due to the assumption, shared by
most K-W models, that inflation is proportional to excess demand. Excess
aggregate demand equals planned consumption plus planned investment less
XsOther examples include Rose (1969), Stein (1969, 1970, 1971), Nagatani (1969), Tsiang
(1969), Hahn (1969) and Fischer (1972).
16The "Keynes"part of the model. Other Keynesianfeatures are also incorporated by some
authors.
output, c + i - y. Since planned savings equals y - c, the price dynamics are

given by
7r = a . ( i - s). (1.15)
The unpleasant implication of this specification is that inflation, even in the

steady state, requires unfulfilled demand. Output must be rationed between
investment and consumption and the choice of rationing scheme turns out to be
one of the determining factors of the steady-state characteristics of the model.
A more reasonable alternative, due to Stein (1971) and Fishcher (1972), takes
the view that only unexpected inflation is due to market disequilibrium:
~- = ~-* + A - ( i - s). (1.16)
In the long run, 7r = ~-* and there is no discrepancy between planned and
actual savings nor between planned and actual consumption. With perfect
foresight, however, 7r is always equal to ~r* and (1.16) implies that the market
is always in equilibrium, which effectively transforms the model to a market-
clearing one. Reconciliation of short-run disequilibrium and long-run equilib-
rium is possible if expectations are formed in alternative ways, for example
adaptively:
~-* =/3-(Tr - 7r*). (1.17)
Following Fischer (1972) we can specify the investment demand function as a

stock adjustment demand:
i=nk+~b(k d-k), ~b'>0, (1.18)
where the desired capital stock, k d, is assumed to depend positively on the

difference between the expected nominal return on capital, f ' ( k ) + ~*, and the
17
nominal interest rate, p:
ka=k(f'(k)+rc*-p), k'>O. (1.19)
The nominal interest rate, p, is determined by equilibrium in the bond

market, where the demand for bonds is:
b d = b ( f ( k ) + 7r*, p, k + m ) , 61 < 0, b 2 > 0, b3> 0, (1.20)
17This is the "Wicksell" feature of the model.

and the supply of bonds, b s, is exogenously given (b E= 0, for example, if we

want to examine an economy without bonds).
The implications of this model are examined in Fischer (1972) who shows
that despite the alternative characterization of the short-run dynamics, the
effect of inflation on steady-state capital accumulation is positive, as in the
neoclassical model. So long as market disequilibrium is limited to the short-run
dynamics of K - W models, the steady-state effect of inflation on capital seems
not to be significantly different from the neoclassical model, ls'w
2. Money in the utility and production function
2.1. The Sidrauski model
The first formulation of a monetary growth model in an explicitly optimizing

framework is due to Sidrauski (1967a). His formulation is based on Ramsey's
classic (1928) paper on optimal savings behavior and as a result it resolves the
objection to non-optimizing models. An infinitely-lived growing family maxim-
izes the utility of its members by solving an intertemporal maximization
problem. Money is introduced by assuming that in addition to consumption,
utility is derived from the flow of services derived from real money holdings.
The utility functional to be maximized is then:
W= ~o u(ct, m , ) . e a, d t , (2.1)
where 6 is the rate of time preference of the family.2° At each point in time real
non-human wealth, a, is allocated between capital and real cash balances as in
(1.2) which is rewritten here for convenience:
a = k + m. (2.2)
Real per capita assets accumulate according to
d=f(k)+ x-c-n.a-~.m, (2.3)
iSThere are, however, exceptions to this statement. See, for example, the models in Stein
(1971).
19See also Hayakawa (1986) who reaches a similar conclusion in an optimizing model with
disequilibrium dynamics.
2°Unless otherwise specified the notation is the same as in the previous section. In particular,
lower-case letters denote per capita quantities. As before, most time subscripts are suppressed.
w h e r e x d e n o t e s g o v e r n m e n t t r a n s f e r s . 21'22 T h e o b j e c t i v e , t h e n , is to m a x i m i z e
t h e w e l f a r e f u n c t i o n a l (2.1) s u b j e c t to t h e s t o c k c o n s t r a i n t (2.2) a n d t h e flow
c o n s t r a i n t (2.3). T o solve t h e p r o b l e m w e w r i t e t h e p r e s e n t v a l u e H a m i l t o n i a n :
Y(= u(c, m) + q" ( f ( k ) + x - 7r" m - c - a. n) + A. ( a - k - m), (2.4)
w h e r e q is t h e c o s t a t e v a r i a b l e a s s o c i a t e d with the flow c o n s t r a i n t (2.3) a n d A is

t h e L a g r a n g i a n m u l t i p l i e r a s s o c i a t e d with t h e stock c o n s t r a i n t . N e c e s s a r y
c o n d i t i o n s for an i n t e r n a l s o l u t i o n are:
t~ = (6 + n ) . q - A, (2.5)
q" f k - A =0, (2.6)
/'/m -- q " 7r - A = 0 , (2.7)
u c- q = 0. (2.8)
S u b s t i t u t i o n o f (2.6) i n t o (2.5) gives:
~) = (6 + n - f k ) - q, (2.9)
which determines the steady-state rate of interest:
fk = 6 + n . (2.10)
S i d r a u s k i ' s s t a r t l i n g result was t h a t in this s i m p l e o p t i m i z i n g m o n e t a r y g r o w t h

m o d e l t h e real r a t e o f i n t e r e s t is i n d e p e n d e n t o f inflation a n d t h e r a t e o f m o n e y
g r o w t h . 23 F u r t h e r m o r e , since, in this m o d e l , t h e r e is a u n i q u e m a p p i n g f r o m
t h e m a r g i n a l p r o d u c t o f c a p i t a l to t h e level o f c a p i t a l i n t e n s i t y , c a p i t a l is also
i n d e p e n d e n t o f inflation. T h u s , m o n e y is superneutra124 a n d t h e T o b i n effect is
invalidated.
2IIn equation (2.3) assets accumulate due to the return of holding capital, f(k), and government
transfers, x. They decumulate due to consumption, c, and the (negative) return on real money
holdings, ~- • m. The remaining term, n - a, simply reflects the required asset accumulation that is
necessary to retain a per capita level of assets in the presence of population growth.
22It is straightforward to set up the model as a decentralized competitive economy. We set up a
command economy here for simplicity. The two problems have the same solution.
23Although, as shown by Fischer (1979), this holds only in the steady state. We return to this
result in the next section.
24Inflation, however, does affect the demand for real balances, m, and affects welfare since
money is an argument in the utility function. These issues are discussed in more detail elsewhere in
the Handbook.
There are several ways to identify the cause of the difference in the Sidrauski
and Tobin results. To make the argument comparable to the discussion of the
previous section we will identify the differences in terms of the portfolio
decision and savings behavior. In the Sidrauski model the portfolio decision
and the savings behavior are derived simultaneously from the necessary
conditions for the solution of the problem. Elimination of q and a from these
conditions results in:
u .(k + = ) - =O, (2.11)
- u c . ( 6 + 7r + n ) + u m + Uccd + Ucmrh=O. (2.12)
Equation (2.11) can be interpreted as the portfolio decision corresponding to

equations (1.8) or (1.9) of the Tobin model. To make this more transparent we
can examine the special case of the logarithmic utility function:
u(c, m) = log(c) + log(m). (2.13)
Now, (2.11) becomes:
m = (r + 7r)-1c, (2.14)
which corresponds exactly to one of the money demand equations in (1.9). It is

therefore clear that the difference between the two models lies in the specifica-
tion of the savings behavior. Equation (2.12) does not quite correspond to the
reduced form consumption function. In the steady state and using the utility
function (2.13), however, the equation simplifies to:
c = ( 8 + Tr + n ) . m . (2.15)
This can be compared to the consumption function specification in (1.13). As

was mentioned in the previous section, if, for a given level of assets, inflation
has a positive effect on consumption, then the Tobin effect can be neutralized
or be overturned.
The superneutrality of money is not, however, a general result within the
optimizing framework. In fact it seems to be obtained only as a special case.
There are two classes of models that originated from the Sidrauski model and
result in non-neutralities. One class, in tune with the original Tobin model,
shows that the Fisher relation does not necessarily hold, even in optimizing
models that retain most of Sidrauski's assumptions. The other consists of cases
in which the Fisher relation continues to hold but the one-to-one mapping from
the real interest rate to capital intensity breaks down. For Sidrauski's own
model, equation (2.10) says that the real rate of interest is invariant to the rate
of inflation so the Fisher relation holds across steady states.
We consider the second class of models first. To break down the correspond-
ence between the interest rate and capital, another variable input of production
must be introduced whose optimal level changes with inflation. This introduces
an additional margin in the maximization problem which equates the marginal
product of capital to the marginal benefit from varying the other input.
2.2. Variations of the Sidrauski model
One such case is that of money in the production function. Suppose, for
example, that money is held by firms to facilitate production and can therefore
be considered as a complementary factor to capital:
y =f(k,m), fk, fm > 0 . (2.16)
Money may still be an argument in the utility function, but for simplicity we
will assume it no longer is. The utility functional is now:
W = f o u(c,)" e -~' dt, (2.17)
and is being maximized subject to the same constraints as before (with the
additional argument in the production function). The new Hamiltonian is:
Y(=u(c)+q.(f(k,m)+x-Tr.m-c-a.n)+h.(a-k-m). (2.18)
The necessary conditions are (2.5), (2.6), (2.8) and
q" fm - - q" 7r - h = 0, (2.19)
which replaces (2.7). As before, the necessary conditions imply that in the
steady state (2.10) holds so the marginal product of capital is independent of
the growth rate of money. Equation (2.19), however, implies an additional
condition that must be met by the marginal product of capital, that is
fk = fm -- 7"r. (2.20)
As a result, the effect of an increase in inflation on capital accumulation is

ambiguous and depends on the partial derivatives of the production function: 25
dk fkm
dO - fmmfkk -- (fk,~) 2 " (2.21)
If the production function is concave, and fkm > 0, then inflation is negatively
related to capital holdings. We will return to the ambiguity of this particular
case in Section 4.
Even if money does not appear in the production function, however,
non-neutrality is obtained by simply treating labor input as another decision
variable. 26 When leisure is an argument in the utility function, labor supply is
not inelastic. Then capital per capita is not equivalent to capital per labor unit.
Since the interest rate equals the marginal product of capital normalized by
labor units, even if the real interest rate is invariant to inflation, capital per
capita will not be invariant due to the effect of inflation on labor supply. Let l
be an index of leisure varying between 0 and 1. The production function can be
written:
y = i l k , l) = f ( k / ( 1 - l ) ) . (2.22)
The utility functional is now:
W = f o u(ct' m t ' l,). e -~' d t . (2.23)
The new Hamiltonian is:
Y ( = u ( c , m , l) + q ' ( f ( k , I) + x - 7r.m- c-a.n)+ A.(a- k- m).

(2.24)
Necessary conditions are, as in the original problem, (2.5)-(2.8), but there is

now an additional margin:
u, - q. ft = 0, (2.25)
which implies the following relationship that must be satisfied by the marginal
product of capital in addition to (2.10):
uc (2.26)
L = u~-(1 - l) "
25This ambiguitywas pointed out by Marty (1968). A detailed derivation appears in Fischer
(1983).
26Leisure was first introduced into the model by Brock (1974).
As a result, money is no longer neutral but the direction of the effect on capital
is not obvious. In particular, the direction of the result depends on whether a
change in money affects the marginal utility of leisure more or less than the
• 27
marginal utility of consumptton.
The major methodological problem with this type of model is exactly the fact
that the direction of the non-neutralities obtained depends on quantities for
which no strong prior can possibly exist• The introduction of money into the
utility and production functions is, indeed, a useful device which allows for
simultaneous examination of optimal savings and money demand. This, as we
saw earlier, is necessary for answering the question at hand. It is also
reasonable to accept a priori the positive sign of the partial derivatives of
money in the two functions. But no more. Unfortunately, the answer turns out
to depend on the cross derivatives of money with other arguments in utility or
production which makes these models unsuitable for settling the debate as a
"practical matter". 2*
Models in which the Fisher relation is violated provide a more promising use
of the money-in-the-utility-or-production-function approach for examining
non-neutralities• We now turn to those models.
3. The Tobin effect and the Fisher relation
The optimizing models we examined in the previous section share the charac-
teristic of considering a world that consists of a fixed number of large infinitely
lived families. Each family makes a decision about how much to consume and
save taking into account the welfare of all future generations. As a result the
steady-state real interest rate is set according to a modified golden rule and
depends only on the rates of time preference and population growth and not on
any monetary variables• Thus, the real interest rate is independent of
inflation - the Fisher relation. On the other hand, if the optimization problem
does not involve maximizing the welfare of all future members of the family,
the steady-state real interest rate is not determined by a relation like the
modified golden rule and therefore may depend on monetary variables. Then,
an increase in the inflation rate could result in a less than one-to-one increase
of the nominal interest rate - a decrease of the real rate - and the Tobin effect
would apply• The intuition, due to Diamond (1965), was developed in a
different context showing how government deficits can affect capital accumula-
tion. To the extent that individuals, for some reason, hold money, the
27This is shown in Danthine (1985).

28It is a separate question whether infinite-horizon optimization models are a suitable vehicle in
the first place for discussing any "practical" matter. One could easily have grave doubts.
242 A• Orphanides and R . M . Solow
seigniorage collected by the government represents an alternative form of

changing government indebtedness and Diamond's results become relevant for
the money and growth literature as well.
To examine the implications of this disconnectedness with the future we
must turn to lifecycle models with overlapping generations (OLG). Since OLG
models with money are covered in detail elsewhere in this Handbook, the
analysis here will be brief. We will examine only steady-state results and we
will bypass the important issues of the possible multiplicity of equilibria,
stability of equilibria, and equilibria outside the steady state•
3.1. The two-period O L G model with money
In the typical finite life models individuals follow a lifecycle pattern of

consumption and savings• They accumulate wealth in the form of capital and
money when young, in order to consume it when they retire• At each point in
time several generations coexist. In the simplest model, due to Samuelson
(1958), individuals live for just two periods• Wealth continuously changes
hands as the old exchange their savings (kept in the form of money and capital)
for goods produced by the young. In Samuelson's pure consumption-loans
model, money is assumed not to provide any services that enter either the
production or utility function and is held only as a means of intergenerational
trade• As a result, money is not held when it is dominated in rate of return by
another asset and the model is unsuitable for examination of the link between
29
inflation and capital accumulation. In this section we examine the implications
•
of assuming, as with the Sidrauski model, that money enters the utility function
directly• This type of model has been introduced in the money and growth
literature by Stein (1970) and more recently examined by Carmichael (1982),
Drazen (1981), Gale (1983), and Weiss (1980)• When young, individuals
maximize a utility function of the form:
W = W(cl, c2, m l , m2), (3.1)
where c i and m i (i = 1, 2) denote consumption and real money holdings in the

two periods of life.3° A portion of first-period income is saved either in the
29For a more detailed examination of O L G models with fiat m o n e y , see the volume edited by
Kareken and Wallace (1980) and the chapters on the O L G model and o p t i m u m quantity of m o n e y
in this Handbook.
3°We will abstract from time subscripts whenever possible since we will only deal with steady
states. In more detail we should have written W, = W(cl~t, c2.~+1, ml, ,, m2,t+l), where W, denotes
the utility of an individual who is young at time t; the first subscript denotes the age of the
individual and the second subscript denotes the time.
form of capital or in the form of money. In the second period of his life the
individual consumes his income plus whatever he has accumulated from his
first-period savings. Despite the similarities with the Sidrauski model several
variations of this model exist. They are due to choices that were meaningless in
the one family Sidrauski model but are important here. In the O L G model one
must specify: (i) whether the individual works in both periods of his life or just
when he is young and in the first case, whether the wage is the same for young
and old; (ii) whether utility is derived from holding money just in the first
period, or in both periods (if in both periods then one must explain what
happens to second-period money holdings when the individual dies); and (iii)
how seigniorage is being a l l o c a t e d - whether the government give it to the
young or to the old or to both. The importance of these assumptions is that
they affect the pattern of the lifecycle savings of an individual and, as a result,
the aggregate level of wealth in the economy and therefore aggregate capital.
To examine this in more detail consider the following example. The individual
needs to hold money when he is young to derive utility and he maximizes
1
W = U(Cl) + ) ~ ' +( 1 U(c2) + L ( m ) , (3.2)
where m is money holdings per young person. Only the young work, receive a
wage, w, and save some of their income in money, m, and capital, k. Only the
young hold money and capital. As soon as an individual becomes old he
exchanges his money and capital for the consumption good. In addition only
the old receive transfers, x, from the government. In equilibrium, the real
value of the transfers, x, is such that real total seigniorage equals total real
transfers but, as in the Sidrauski model, we assume that the individuals
consider it to be unrelated to their actions. Consumption in the first and second
periods is:
c1= w- k-m, (3.3)
c 2 = k(1 + r) + m / ( 1 + 7r) + x . (3.4)
Solving the problem faced by the young results in the following conditions:
(1+ r)
Or(el) = Or(c2)" (1 -~- ~ ) ' (3.5)
L ' ( m ) = U'(Cl)"
( 1 -- (1 -~- ~r)'(1
1 + r) ) " (3.6)
Condition (3.6) simply states that the marginal utility of first-period con-
sumption is equated to the marginal utility of (first-period) money holdings

appropriately discounted and is the discrete time equivalent of condition (2.11)
which obtained in the Sidrauski model. 31
Condition (3.5) is the equivalent of the dynamic condition of the Sidrauski
problem (2.9) or (2.12). In the steady state (2.9) simplified to the modified
golden rule condition that the real interest rate equals the rate of time
preference plus the rate at which the family grows. Here, however, this would
only be true if consumption of an individual were the same in both periods of
his life. In that case (3.5) would imply that r is equal to 6, which exactly
corresponds to the modified golden rule since there is no "family" growth here.
There is no reason, however, for consumption to be the same in the two
periods of life. The lifetime consumption pattern is determined together with
the savings decision and portfolio choice when the young solve their optimiza-
tion problem. In equilibrium the real interest rate is therefore determined as a
function of the consumption pattern.
Unlike the Sidrauski model, the savings pattern of an individual in the steady
state matters in the determination of the aggregate capital level. In other
words, it is not only the value of the lifetime consumption of an individual that
matters, but the actual allocation of his lifetime consumption between the first
and second periods of his life. When viewed from the aggregate level it is this
additional margin that invalidates the superneutrality result. Inflation, there-
fore, has an effect on capital accumulation in this model by changing the slope
of the individual consumption path. An alternative interpretation corresponds
more closely to Tobin's original mechanism. Inflation increases the relative
attractiveness of investing in the form of capital. This has a negative effect on
the return to capital thereby causing an increase in first-period consumption.
To examine the effect of inflation further, we close the model assuming con-
stant returns to scale production and competitive markets as in the Sidrauski
model. In equilibrium, the interest rate and wage are determined from:
r = f'(k), (3.7)
w =f(k) - (3.8)
where f ( k ) is output per young (since only the young work).

Assuming, for simplicity, that there is no population growth, the number of
young equals the number of old. Then inflation, ~r, equals the growth rate of
money, 0, and seigniorage per young person, Ore, equals the transfer per old
31Note that when r and ~r are close to zero, the expression in the parentheses is approximately
equal to r + 7r, which is what appears in condition (2.11).
person, x. In equilibrium, the steady-state consumption path is:
c 1 = f ( k ) - k . (l + f ' ( k ) ) - m , (3.9)
c 2 = k" (1 + f ' ( k ) ) + m , (3.10)
and the first-order conditions, (3.5) and (3.6), imply:
(1 + f ' ( k ) )
U'(c,)=U'(c2). (1+6) ' (3.11)
( 1 ) (3.12)
L'(m) = U'(c,). 1 - ( 1 + 0). (1 + f ' ( k ) ) "
Straightforward comparative statics on (3.9)-(3.12) shows that as long as the

stability condition for the model is satisfied, d k / d O > 0, and in the steady state
an increase in inflation unambiguously increases steady-state capital.
This precise result, however, does not hold for all variants of the two-period
OLG model. Variation, whenever present, comes from the allocation of
seigniorage. In the model we just described, the sign of the effect of inflation
on capital is invariant to the allocation of seigniorage, but the size of the effect
is not. If all seigniorage is given to the young instead of the old, equations (3.9)
and (3.10) become:
c I =f(k)- k . (1 + f ' ( k ) ) - (I- 0)" m , (3.13)

in
c2 = k.(l +f'(k)) + - - (3.14)
(1 + 0 ) '
and the comparative statics showing the effect of inflation on steady-state

capital are now determined by (3.11)-(3.14). Capital holdings become smaller
and the consumption path flatter, but the steady-state effect of inflation on
capital holdings is positive, nonetheless.
In Drazen's model, money provides utility in both periods of life, and is
therefore held by both the yound and the old. He shows that, as with the
model outlined above, if transfer payments are fixed, then an increase in
inflation increases the demand for capital by the young. But an increase in the
rate of inflation also increases the seigniorage collected by the government. If
that seigniorage is given to the old, it represents an increase in second-period
income which has the effect of reducing first-period savings. This transfer
mechanism has the same effect as the introduction of government debt in the
Diamond model and tends to reduce the demand for capital. In the model
outlined above this effect is not strong enough to overturn the positive effect of
inflation on capital. We chose to illustrate the extreme case in which all
seigniorage is given to the old and saw that even in that case the Tobin effect
prevails. In Drazen's model, however, the seigniorage transfer effect is so large
that in equilibrium the relationship between inflation and capital is reversed. If
the young receive the seigniorage from holding money, capital increases with
inflation, while if the old are given the seigniorage the demand for capital
decreases with inflation.
In general, the two-period life O L G models do provide a formal justification
of the Tobin effect in an explicitly optimizing framework. It is disappointing
that the effect can be reversed in some versions by the mere redistribution of
seigniorage from one group of individuals to another, an effect whose impor-
tance would not a priori seem relevant. This problem may be due to the
unnatural time scale of the two-period O L G models. A priori, it is at least as
reasonable to assume that money is held during both periods of life as it is to
assume that it is held only in the first. The problem, however, is that one
period is supposed to represent many decades. The debate as to whether these
models are appropriate for studying monetary phenomena at all is still un-
settled and its resolution is outside our scope. 3 2
3.2. Family disconnectedness with infinite horizons
An alternative model not subject to the criticisms of the two-period O L G

model emphasizes not the finiteness of each individual's horizon but the
disconnectedness of infinitely lived individuals born in different times. It is
much more similar to the Sidrauski model, and as a result better illustrates why
superneutrality fails when dissimilarities among individuals are present. The
model is based on the Blanchard (1985) formulation of Yaari's (1965) infinite
horizon-uncertain lifetime model. The variant discussed below follows Weil
(1986) and Whitesell (1988).
In this model, in every instant, a new generation of infinitely lived in-
dividuals/families is born which is completely disconnected from past genera-
tions. Like the O L G model there is no family growth comparable to the
Sidrauski model. Population growth is completely due to the birth of new
families. Families differ in the time of their birth much in the same way the old
differ from the young in the O L G model. The family maximization problem is
exactly the same as in Sidrauski and the interest rate and wage are assumed
determined in competitive markets as in the Sidrauski and O L G models. A
3ZSee, in particular, the criticism in Tobin (1980) which relates the issue to the money and
growth issue.
family born at time s faces the following optimization p r o b l e m at time t > s:

maximize the welfare function
Ws, t = U(C.... ms,o)" e -a(v-t) dv (3.15)
subject to the portfolio selection constraint,
a,. = k , . v + m .... Vv>t, (3.16)
and the asset accumulation constraint,
ds,v=r~'k,,v+w,+x~-%'m,,~ -c .... Vv>t. (3.17)
H e r e , the first subscript indicates the time of birth of the family and all
quantities represents the real per capita values of the variables for individual
m e m b e r s of any family born at time s. Variables without the first subscript are
variables that have the same value for individuals of all families. H e r e it is
assumed that, regardless of age, all individuals supply one unit of labor and
receive the same wage, w, and the same government transfer, x. 33
To keep the model tractable later on, we will assume that the instantaneous
utility function is of the logarithmic form:
u ( c .... m~.v) = log(cs,~) + l o g ( m , , o ) . (3.18)
The individual's p r o b l e m is exactly the same as in the Sidrauski model. As we

have seen in Section 2, the first-order conditions implied by the maximization
are:
dls,v = (6 - ro). q . . . . (3.19)
Cs.~ = ( % + ro). m . . . . (3.20)
1/c,,v = q . . . . (3.21)
where qs,v is the costate variable corresponding to the asset accumulation

equation of a representative individual born at time s. In the Sidrauski model,
in the steady state all individuals have the same level of consumption which
3~The convention we follow is that variables with an age subscript, z.... represent per capita
values for members of one generation, while variables without an age subscript, zv, represent per
capita values for the whole population. As before, variables without any subscripts represent the
steady-state per capita values for the whole population.
248 A. Orphanidesand R.M. Solow
must therefore be fixed at a constant level. If that were true here, then Cs,v
would equal c s_ .... Vr, and qs,~ would be a constant. In that case equation
(3.19) would collapse to the Sidrauski steady-state superneutrality. Here,
however, steady state simply requires that c,,v = c,+~,~+,, V r > 0 . The con-
sumption of individuals of different generations may be different, as in the
O L G model. But since in the steady state the cross-section of the consumption
of individuals of different ages at a given instant corresponds to the time path
of consumption for a given individual, it follows that individual consumption is
not necessarily a constant. This highlights the key difference with the Sidrauski
model. Individual consumption patterns are not required to be completely flat
in the steady state. Inflation can affect capital accumulation by changing the
relative price of consumption between any two instants thereby changing the
pattern of individual consumption. Forward integration of (3.19) and substitu-
tion of (3.21) gives the path of individual consumption:
Let us define human capital, h, as the present value of future non-interest

income: 34
h,~=(xv+ wv)'exp(-ftVru'dtz)dv. (3.23)
Then, the individual's total real wealth, b, at time t is:
bs,t =-- ks. t q- ms, , + h t , (3.24)
and his lifetime budget constraint, which equates total wealth with the cost of
total future purchases of consumption and money services, can be written as: 35
bs,,=~c,,v'exp(-~Vr,'dl.t) dv
+ f~ (% + rv). m,,v .exp(-;V r, "dlx) dv . (3.25)
Substituting the first-order condition (3.20) and solving using equation (3.22)
34Notice that human wealth is the same for all individuals regardless of their date of birth since it
does not depend on current asset wealth-the only distinguishing characteristic between genera-
tions.
35Formally, (3.25) can be derived by forward integration of the asset accumulation equation
(3.17) and a transversality condition.
gives us money holdings and consumption as a function of wealth:
cs., = ~ . b s . , / 2 , (3.26)
ms. , = 6 . b s . , / ( 2 . (zr t + r,)) . (3.27)
In order to examine the behavior of the economy we must transform the

relationships describing generation specific variables to economy-wide aggre-
gates. Assuming that the number of families increases at rate n, the economy-
wide per capita average for a variable z is obtained by integration:
t
z, = e -n't
•
f - ~
zs. , n . en'S d s .
.
(3.28)
Aggregation using equation (3.28) implies that equations (3.20), (3.24) and
(3.26) hold unchanged for the economy-wide aggregates as they do for the
individuals. These, together with the dynamic equations
r h t l m , = 0 - n - 7r~ , (3.29)
[c, = f ( k , ) - n " k , - c, , (3.30)

I~, = - ( w , + O. m , ) + r , . h, , (3.31)
completely describe the dynamic behavior of the economy. 36 Equation (3.31) is

obtained by differentiating (3.23) and setting transfers, xt, equal to per capita
seigniorage, 0. m,.
When population growth is zero, the model is identical to the Sidrauski
model with no population growth. The two models diverge when population
growth is positive as the Sidrauski model assumes growth occurs within the
(fixed number of) existing families, whereas this model assumes growth occurs
by the creation of new families (of fixed size).37As a result, although the
national income and real money growth identities, (3.29) and (3.30), are
identical in both models the consumption function (3.26) is not.
Elimination of all other variables from the steady-state system results in the
following equation for steady-state capital:
f(k)-n.k=2.f,(k~ 2"f(k)-n'k+n-:(f(k)-n'k)] (3.32)

f'(k)+o-n J
36In equilibrium, the interest rate and wage are, of course, set as described in equations (3.7)
and (3.8).
37The assumption of no intra-family growth can be relaxed.
As expected, when n = 0 (3.32) simplifies to the modified golden rule f ' ( k ) = `3

and the superneutrality result prevails. On the other hand, it is clear that when
n ¢ 0, then the rate of growth of money, 0, affects the steady-state level of
capital. In fact, an increase in the rate of growth of money unambiguously
implies a higher level of steady state capital. 38
The Tobin effect has been shown to arise naturally in models in which
money enters the utility function when there is individual heterogeneity in the
steady state. The key characteristic of models that attain non-neutrality and the
simultaneous invalidation of the Fisher relation seems to be the relaxation of
the requirement that steady-state consumption be the same always and for all.
The superneutrality result in the Sidrauski model is achieved from a single
first-order condition of the individual maximization problem,
OU, OU,+, ( l + f ' ( k ) )

Oc----~,= Oc,+-----]" (1 + ,3) ' (3.33)
when the model requires that in steady state,
OU] Oc, = OU,+ ll Oc,+ 1 . (3.34)
Introducing some slope to individual consumption paths allows Tobin's port-

folio mechanism to have a real effect even though other effects at work, such
as the distribution of seignorage, may make the Tobin effect ambiguous.
It is clear from (3.34) that individual heterogeneity is not needed for the
non-neutrality result. Michener (1979) shows that if the time separability of the
utility function is relaxed in the Sidrauski model neutrality fails. According to
Carmichael (1982), one of the necessary conditions for the neutrality result is
that "the individual's utility function [be] separable with a constant discount
rate". Fischer (1979) shows that neutrality does not hold in the Sidrauski
model during the transition to the steady state [see also Asako (1983)]. Again,
what is at work is the fact that outside of the steady state (3.34) does not hold.
Inflation changes the slope of the consumption path during the transition.
Danthine, Donaldson and Smith (1987) build a stochastic version of the model
by introducing stochastic shocks to productivity. (3.34) does not hold even
after the economy achieves stationarity (the stochastic equivalent of a steady
state). As a result neutrality fails in the sense that the stationary distribution of
the real interest rate and capital depends on the rate of growth of money.
Furthermore, they use numerical simulations to show that when the utility
function has a constant positive elasticity of substitution the Tobin effect
holds - an increase of the rate of growth of money lowers the real interest rate
and increases capital, on average.
38This is shown in Whitesell (1988).

4. Cash in advance and transactions demand
In Sections 2 and 3 we illustrated several models in which inflation positively

affects capital and we attempted to explain why this result does not always
obtain. The indeterminacy was shown to be due, sometimes, to a simplifying
assumption shared in all of those models, namely that money is held simply
because it provides services that directly yield utility or increase the productivi-
ty of capital. Even though these models overcome one of the two key criticisms
of the original Tobin model - that individual behavior must be consistent with
the optimization problems faced by i n d i v i d u a l s - t h e y fail to provide an
adequate explanation of why money is held, and thus do not address the
second key criticism of the Tobin model. In particular, the transactions role of
money is not adequately detailed even though in the absence of a transactions
demand for money there would be no reason for money to be held at all.
This omission is dealt with in a number of models which give greater
emphasis to the exact specification of the transactions demand for money.
These models are the focus of this section.
4.1. A "shopping costs" model
We start by examining a model which is directly comparable to the models in

Section 2. An infinitely lived family maximizes a welfare function subject to a
neoclassical production function. The services of money do not appear directly
in either the production or utility f u n c t i o n - rather it is assumed that the
presence of money facilitates the transactions that are necessary for the
delivery a n d / o r consumption of output.
A function of real money holdings, v(m), represents the fraction of real
resources that are necessary for the task of facilitating transactions. Real
money holdings provide "shopping services" in the sense that the more money
is held the more real resources are freed from the transactions task, thus
v'(m) < 0 . The specification allows for the explicit recognition that there are
decreasing returns to the services that can be provided by holding money. Each
additional unit of real money held frees a smaller fraction of resources than the
unit preceding it, thus v"(m)> O.
A question of importance in this model is whether the type of transactions
that can be facilitated by money holdings is necessary in order simply to
consume output or in order to produce it at all.
We will first consider the first alternative: only consumers find the services of
money useful.
The optimization problem faced by the individual/family is to maximize the
welfare function,
V = f o u ( c , ) " e -~' d t , (4.1)
subject to the portfolio decision constraint,
a = m + k, (4.2)
and the asset accumulation equation,
gt = f ( k ) + x- c" (1 + v ( m ) ) - n'a- 7r.m. (4.3)
Notice that ( 4 . 1 ) - ( 4 . 3 ) correspond to equations (2.1)-(2.3) of the Sidrauski

model and in fact the necessary conditions (2.5) and (2.6) obtain here as well.
But those were exactly the conditions determining that the rate of interest is
independent of inflation in the steady state. Thus, Sidrauski's neutrality result
obtains here in a model in which the transactions role of m o n e y is explicitly
modelled and the need to introduce m o n e y in either the utility or production
function does not arise.
The alternative specification is to assume that m o n e y facilitates transactions
necessary to produce output and not just consume it. 39 The problem becomes
one of maximizing the welfare function (4.1) subject to (4.2) and the asset
accumulation equation:
= f ( k ) " [1 - v(m)l + x - c - n . a - 7 r - m . (4.4)
This model is operationally identical to the model of m o n e y in the production

function that we examined in Section 2. We simply have to m a k e the
transformation:
f ( k , m ) = f ( k ) . (1 - v ( m ) ) . (4.5)
In Section 2 we have seen that the effect of inflation on capital is ambiguous

and depends on the derivatives of the production function. But here we can
give an interpretation to those derivatives. In the steady state the analogues of
conditions (2.10) and (2.20) are now:
3 = f ' . (1 - v ) , (4.6)
f"(1- v) = - f " v' - ~ ' , (4.7)
39This specification is due to Dornbusch and Frenkel (1973).

which imply:
dk -v'-f'
(4.8)
dO -(1- v)- f". v". f - ( f ' . v') 2 "
Since the n u m e r a t o r of this expression is positive, the sign o f the effect of

inflation on capital is d e t e r m i n e d by the sign of the d e n o m i n a t o r in (4.8):
dk/dO~O, as ( 1 - v ) ' f " ' v " ' f +(f"v')2~O.
If there are no decreasing returns to saving shopping costs by holding m o n e y

(v " = 0), then higher inflation results in higher steady-state capital. If the
e c o n o m y is close to being fully liquid - in the sense that additional real m o n e y
holdings provide only minimal resource savings - then v ' is small and increases
in inflation reduce steady-state capital. In general, h o w e v e r , the effect is
obviously ambiguous.
T o see the advantages of explicitly modelling the role of m o n e y and the
pitfalls of not doing so we can c o m p a r e directly (4.8) with (2.21):
dk fkm
dO = - fmm fkk -- (fkm) 2 ' (2.21)
W h e n m o n e y is simply considered as an additional input in p r o d u c t i o n it seems

natural to require convexity which determines the sign of the d e n o m i n a t o r in
(2.21). T h e n the ambiguity of the effect of inflation is due to the sign of fkm. 4°
Observing (4.7) we note that w h e n the transactions role of m o n e y is explicitly
modelled, f~m is actually u n a m b i g u o u s l y positive and the ambiguity results
exactly f r o m the fact that we c a n n o t simply require the convexity of a
p r o d u c t i o n function w h e n m o n e y is assumed to be one of the inputs. W h a t e v e r
the interpretation, h o w e v e r , the p r i m a r y conclusion we reach is that the effect
of inflation on steady-state capital remains ambiguous.
We have thus shown that w h e n the role of m o n e y as a facilitator of
transactions is specified explicitly, the conclusions regarding the effect of
inflation on steady-state capital accumulation remain u n c h a n g e d . 41 D o u b t s
4°Fischer (t974) examines in detail models of money demand which would result in the firm
behaving as if money entered its production function and studies the restrictions thus placed on the
resulting implicit production function.
4~This is not true of all variables, however. The effects of inflation on money demand are not
identical in the two models. Furthermore, the welfare implications are quite distinct. Inflation is
detrimental to steady-state welfare in the Sidrauski model because the reduced money balances
lower the utility derived by real good consumption even if the level of consumption is not affected
by inflation. In the models examined here, only real goods affect utility, thus inflation has no
welfare implications in the steady state other than the ones due to the induced real consumption
changes.
about the validity of the Tobin effect remain while, at the same time, we
observe that the superneutrality result is a non-result.
What is the exact way in which money facilitates transactions? Admittedly,
this question was not addressed by the models just exmained and was rather
hidden behind the cryptic specification of the function v(m). Unfortunately,
the effect of inflation on capital turned out to depend on the properties of the
function in one of the models examined. The criticism regarding the ambiguity
due to the admission of money in the utility and production functions carries
over to the specification of the function v(m). A possible response to this
criticism is provided by the models we examine next.
4.2. Cash in advance for consumption and investment purchases
In cash-in-advance (CIA) models the role of money as facilitator of transac-

tions is identified by the simple rule that no transaction can take place unless
the money needed for the transaction is held for some time in advance. The
methodological problem presented by these models is that in the absence of
costs of transferring wealth to and from assets providing higher yields, money
would only be held for infinitesimal time intervals and would be of no
economic significance. A simple solution to this problem is to assume that
money must be held for a fixed period of time before a transaction takes
place. 42 H e r e we briefly examine models of this form, concentrating in particu-
lar on any additional intuition that can be gained from them for the money and
growth question.
The simplest model parallels the discrete-time formulation of the Sidrauski
model and was introduced to the money and growth literature by Stockman
(1981). 43 The CIA constraint is that the amount of nominal money that is
required for a transaction in one period must be held for at least one period in
advance. An infinitely lived individual maximizes the welfare function,
~, (1 + 6)-'u(c,), (4.9)
t=O
subject to a dynamic budget constraint,
k,+~ - k, + m a, - m,_, - P,_,/P, = f ( k , ) + x , - ct, (4.10)
where m d represents the amount of real money held at the end of period t and
42The undesirable implications of this ad hoc assumption will be briefly discussed later.
43OLG models with cash-in-advance constraints are covered in Chapter 7 of this Handbook.
m - mt_ 1 • et_l/Pt+ x t equals post-transfer real money holdings at the begin-

ning of period t. Equation (4.10) corresponds to the asset accumulation
equation and asset selection constraint of the models we examined earlier. As
is, the problem has a simple solution for money demand, i.e. no money is ever
held. With positive inflation, money is strictly dominated by capital as an asset
and as before we assume that the individual takes the transfer payment as
independent of his saving and portfolio decisions. Next we must specify the
liquidity constraint. A key assumption in this model, as in the models
examined earlier, is whether the liquidity-cash-in-advance constraint pertains
to the purchases of consumption goods or all goods, including investment.
Under the first alternative the liquidity constraint is simply:
mt>~ct, (4.11)
whereas under the second alternative it is:
m , >-- c, + k t + ~ - k , . (4.12)
The similarities with the "shopping costs" model discussed above are quite
obvious. Not surprisingly, the two models provide similar results. When only
consumption is subject to the liquidity constraint, (4.11), then the steady-state
real rate of interest and capital are independent of inflation. On the other
hand, if investment goods as well as consumption goods are subject to the
liquidity constraint, (4.12), then the steady-state real interest r a t e is: 44
r=6.(1 +a).(l +0). (4.13)
Thus, higher inflation is unambiguously associated with higher steady-state real

interest rates and lower capital stock. This strong result is the only basic
difference between the CIA and "shopping costs" models. The reason for the
difference is that in the shopping costs model it is possible to economize on real
money balances and still enjoy the same net level of output by substituting real
resources for money in the transactions process. Here, this is ruled out by
assumption, and this makes the difference in the result less important.
It is, perhaps, of greater importance to gain further intuition as to why,
whenever money is directly connected to production (in addition to or in place
of consumption), there develops a negative effect of inflation on capital
accumulation. The link seems to be the complementarity of money and capital
that appears in these models. This is most direct in the money in the
production function model and in the shopping costs model where fkm is
44The derivationis in Stockman (1981).

presumed positive. In the CIA model the complementarity is indirect but

equally clear. Investment of an additional unit of capital in period t + 1
requires an additional unit of money holdings in period t. Higher inflation
increases the cost of the additional unit of investment by increasing the cost of
holding the money necessary for the investment. Thus, it reduces the (net of
money holding costs) return on a unit of investment. As a result, the demand
for capital is reduced and less money is held.
The complementarity of money and capital, whenever present, creates a
negative effect of inflation on capital.
4.3. A digression to inside money
Until now, we have examined models in which all money is assumed to be of

the outside form, representing non-interest-bearing government debt. In reality
a large part of money supply is of the inside form - bank deposits - represent-
ing claims to the private sector. The distinction is important because aggre-
gated over the private sector, outside money is part of net wealth of the private
sector, whereas inside money is not. Corresponding to at least part of inside
money are loans used to finance the purchase of capital goods. Therefore,
unlike outside money, inside money is not an alternative to holding capital.
We chose to discuss the implications of this distinction here because inside
money can be thought of as being complementary to capital and its presence
has the same effect on the economy as the models discussed in the preceding
paragraphs. An increase in inside money may well represent an increase in
claims to capital holdings.
The importance of the distinction between inside and outside money has
been recognized early in the monetary growth literature in papers by Johnson
(1969) and Marty (1969). Gale (1983) illustrates the importance of the
distinction most clearly in a model similar to the O L G model described by
equations (3.2)-(3.4). We have shown in Section 3 that when all money in the
economy is of the outside variety, Tobin's portfolio effect holds unambiguously
in that model. Gale considers the same model with the alternative assumption
that all money is of the inside variety. Consumers hold money (non-interest-
bearing bank deposits) and there are always investors willing to invest (even
though in equilibrium they make zero profits). As usual, inflation decreases the
demand for real money balances. 4 5 This . .
lmphes . . .
a reduction of. real reside
money which reduces the supply of funds available for investment. Thus,
Tobin's effect is unambiguously reversed when all money is of the inside
variety.
45Inflation is possible because the government can regulate the bank supply of deposits.
4.4. The Tobin effect in a CIA model without capital
The major methodological problem with the rigid CIA model described earlier
is that it requires that cash be held for a fixed time interval before a transaction
takes place. This assumes away the most basic form of economizing cash
balances, that of reducing the average time money is held before it is
s p e n t - increasing the velocity of money.
Romer (1986) develops a model in which the money-holding period is an
endogenous decision. The model is based on the Baumol-Tobin model of
money demand. The individual faces a fixed real cost of making cash withdraw-
als from the bank and must pay for his consumption purchases with cash. Bank
deposits offer a positive rate of return, p, whereas money has a negative real
return due to inflation.
Capital is not explicitly introduced in the model for tractability. As a result
there is no production in the model and no income is received from productive
activity. Rather, it is assumed that the individual receives income in fixed
intervals. Then the effect of inflation on capital accumulation is implicitly
represented by the average bank account balance of the individual. That is,
"capital" is whatever wealth is not held in the form of money. Higher inflation
induces the individual to make trips to the bank more often and make smaller
withdrawals. The net effect is that inflation tends to increase "capital" hold-
ings, thus the Tobin effect seems to hold. Romer observes, however, that the
effect he finds is "insignificant" for any reasonable values of the parameters in
the model and discounts the importance of the Tobin effect he is able to
generate.
Once again, we observe that seemingly small variations in a model change
the conclusions regarding the effect of inflation on capital accumulation.
5. Concluding remarks
We end where Stein ended 20 years ago. Tobin's 1965 paper succeeded in
framing the question that has dominated the literature since: Does the rate of
monetary growth have any long-run effect on the real rate of interest,
capital-intensity, output and welfare? He also established the framework within
which the question would be debated: portfolio choice, where fiat money is one
of several competing assets. It has turned out to be difficult to assess the
"practical" relevance of the Tobin effect precisely because equally plausible
models of portfolio balance can yield quite different answers. (We specify
"practical" relevance to emphasize that steady-state arguments, here as
elsewhere, must not be taken too literally. If money-growth affects real output
for decades at a time but not in the steady state limit, the Tobin effect has won
the ball-game that matters.)
The fundamental difficulty is that we do not yet have any clearly preferred
way to introduce money into models of the real economy, especially those that
feature durable productive assets as well. Models of a monetary economy
without real capital cannot be taken seriously as vehicles for the study of
money-and-growth. Their implications may not survive the introduction of
productive assets; in that case they serve only to mislead. That may well be the
case with extant OLG models.
There are undoubtedly bits and pieces of intuition about the long-run role of
money-growth and inflation to be had from many of the models that have been
proposed. None so far is able to provide a comprehensive understanding of all
the likely effects; and thus none provides a method for sorting out the relative
significance of opposing effects.
How might the situation be improved? The literature so far has concentrated
on the transactions role of money. The precautionary motive for holding
money has been neglected. Correspondingly, deterministic models have pre-
dominated. The effects of permanent uncertainty have not been studied in this
context. To the extent, for instance, that inflation makes the return on real
capital more uncertain (in addition to reducing the real return on money
holdings) it would induce risk-averse agents to save more. Presumably some of
the additional saving could flow towards real assets; the demand for capital
could rise, despite the increased riskiness. No doubt further research would
turn up other effects as well. The point is that uncertainty could be an
important determinant of the longer-lasting effects.
A second line of questioning is suggested by the observation that the
money-and-growth literature generally neglects issues that are taken seriously
in studies of hyperinflation. To the extent, for example, that inflation damages
the efficiency of the transactions technology, the net productivity of real capital
will be lower and so will the demand for capital. It seems unsatisfactory to treat
such questions by simple dichotomy: to say that they matter at "high" rates of
inflation and not at all at "low" rates of inflation. A more unified treatment
would have implications for monetary growth theory.
Finally, we call attention to a gap that exists in all growth theory, not merely
its money-and-growth branch. Short-run macroeconomics and long-run growth
theory have never been properly integrated. It is only a slight caricature to say
that once upon a time the long run was treated casually as a forward extension
of the short run, whereas nowadays the tendency is to treat the short run
casually as a backward extension of the long run. The recent revival of (sort of)
"Keynesian" models based on a microeconomics adequate to the study of
short-run dynamics may offer an opportunity for the integration of demand-
based and supply-based dynamics. The result would probably cast light on the
long-run role of monetary phenomena.
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Chapter 6

MONEY, INFLATION AND GROWTH

ATHANASIOS ORPHANIDES and ROBERT M. SOLOW*

"My main conclusion is that equally plausible models yield fundamentally

seigniorage proceeds can disturb superneutrality: the aggregate saving rate

0.1. Prior beliefs about inflation

Is inflation "good" or " b a d " ? All three possibilities serve as reasonable

0.2. Related questions

States, Geweke (1986) finds evidence in support of the superneutrality of

0.4. The role o f m o n e y in the real economy

0.5. The origins of the money and growth literature

1. The Tobin effect

In the n o n - m o n e t a r y model, capital, k, is the only form of wealth. In the

1.1. The neoclassical model

I~ = s y - (1 - s)(O - rr)m - nk. (1.4)

Since m is real per capita money balances (m = M/PN), it evolves through

In the steady state, 8 7r = 0 - n and the steady-state relation between real

0 = sf(k) - (1 - s)nm - nk. (1.6)

m=~b(r+7 0 -k, ~b'<0, (1.7)

O= s" f ( k ) - (1 - s)" n . O ( f ' ( k ) + O - n)" k - n" k , (1.8)

without changing the result since y is a monotone function of k and in

c=c(a), c'>O. (1.10)

Since, in the steady-state, equilibrium consumption equals net output, if

f ( k ) = c([1 + d ? ( f ' ( k ) + 0 - n ) ] - k ) , (1.11)

and again d k / d O > O, at any stable steady state. 11

s=s(r,-rr), s1>0, s 2 > 0 , (1.12)

c = c(a, ~r), cl > 0 , (1.13)

0 = s- f(k) - n. I,, (1.14)

which is the non-monetary growth model condition of Solow (1956). Levhari

1.2. On stability and uniqueness

The primary objective of this paper is to examine the effects of anticipated

14The exceptions are Hadjimichalakis (1971a, 1971b), Hadjimichalakisand Okuguchi (1979),

1.3. The Keynes-Wicksell model

An alternative to the neoclassical monetary models was developed by Rose

output, c + i - y. Since planned savings equals y - c, the price dynamics are

The unpleasant implication of this specification is that inflation, even in the

~- = ~-* + A - ( i - s). (1.16)

~-* =/3-(Tr - 7r*). (1.17)

Following Fischer (1972) we can specify the investment demand function as a

i=nk+~b(k d-k), ~b'>0, (1.18)

where the desired capital stock, k d, is assumed to depend positively on the

ka=k(f'(k)+rc*-p), k'>O. (1.19)

The nominal interest rate, p, is determined by equilibrium in the bond

b d = b ( f ( k ) + 7r*, p, k + m ) , 61 < 0, b 2 > 0, b3> 0, (1.20)

17This is the "Wicksell" feature of the model.

and the supply of bonds, b s, is exogenously given (b E= 0, for example, if we

2. Money in the utility and production function

2.1. The Sidrauski model

The first formulation of a monetary growth model in an explicitly optimizing

Real per capita assets accumulate according to

d=f(k)+ x-c-n.a-~.m, (2.3)

Y(= u(c, m) + q" ( f ( k ) + x - 7r" m - c - a. n) + A. ( a - k - m), (2.4)

w h e r e q is t h e c o s t a t e v a r i a b l e a s s o c i a t e d with the flow c o n s t r a i n t (2.3) a n d A is

q" f k - A =0, (2.6)

/'/m -- q " 7r - A = 0 , (2.7)

S u b s t i t u t i o n o f (2.6) i n t o (2.5) gives:

which determines the steady-state rate of interest:

S i d r a u s k i ' s s t a r t l i n g result was t h a t in this s i m p l e o p t i m i z i n g m o n e t a r y g r o w t h

u .(k + = ) - =O, (2.11)

- u c . ( 6 + 7r + n ) + u m + Uccd + Ucmrh=O. (2.12)

Equation (2.11) can be interpreted as the portfolio decision corresponding to

u(c, m) = log(c) + log(m). (2.13)

Now, (2.11) becomes:

which corresponds exactly to one of the money demand equations in (1.9). It is