ECON3440C - Adamopoulos Monetary Economics Lecture 5 2021

Monetary Economics II: Theory and Policy
ECON 3440C
Tasso Adamopoulos
York University
Fall 2021
Lecture 5
ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 1 / 60

1. Recap: SME with
Growing Money Supply

Growing Supply of Fiat Money
Constant population, Nt = N for all t.
Money supply grows at the constant (exogenous) rate z > 1 each

period t,
Mt = zMt−1
z = gross rate of money supply expansion.
Real subsidy per old person in t,
1 − z1 Mt vt

at =
Nt−1

Individual Budget Constraints
Budget constraint in first period of life (real),
c1,t + vt · mt ≤ y
Budget constraint in second period of life (real),
c2,t+1 ≤ vt+1 · mt + at+1
Lifetime budget constraint (real),

vt vt
c1,t + · c2,t+1 ≤ y + · at+1
vt+1 vt+1

Rate of return to fiat money
Using the assumptions of stationary equilibrium (c1,t = c1 ) and

constant population (Nt = N),
vt+1 Mt 1
= = <1
vt Mt+1 z
The rate of return to money is constant and equal to the inverse of

the gross rate of fiat money expansion.
Implication: Further, the higher z the lower the rate of return to money.

The budget set with monetary growth
Individual lifetime budget constraint,

vt vt
c1,t + · c2,t+1 ≤ y + · at+1
vt+1 vt+1
Using the assumptions of stationary equilibrium (including that at = a

for all t) and the derived rate of return to money,
c1 + zc2 ≤ y + za

with Growth
Monetary Equilibrium
of Money Supply
to
I
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a.H.is esn.um
I
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real demand
For money
Implications of the monetary equilibrium
The gifts to the old can come only from losses sustained by them or
others.
When the stock of fiat money increases the value of money currently
held by citizens falls in value.
The new money competes with the old money to buy the (same)
goods of the young → this drives up the price of these goods.
The losses are sustained by the holders of the old money → works as
a tax on money holdings.
The value lost to the “inflation tax” is proportional to the amount of

money held.
To reduce exposure to this tax, people will choose to hold less money.

2. Efficiency of Equilibrium with
Growing Money Supply

Efficiency question
Is the expansion of the money stock optimal?

Does it make sense from a welfare perspective?
Is inflation efficient?
Compare budget set to feasible set,

I budget set: shows options available to an individual in a monetary
equilibrium
I feasible set: consumption allocations feasible for the economy
If the budget set coincides with the feasible set then the Golden Rule
allocation is attainable under the monetary equilibrium.

Feasible Set
The government’s expansion of fiat money does not have an effect on

what is feasible in this economy.
Printing money does not alter the amount of goods Nt y available for
distribution between the young and old.
The feasible set is exactly the same as in the basic OLG model,
Nt c1,t + Nt−1 c2,t ≤ Nt y

Feasibility Constraint
Stationary allocation for each generation t,

(
c1,t = c1
c2,t = c2
Constant population Nt = N for all t.
Stationary per capita feasibility constraint,
c1 + c2 ≤ y

Comparison of SME and GRA
To compare the stationary monetary equilibrium (SME) and the

Golden Rule Allocation (GRA) put them on the same graph.
The feasible set line intersects the budget line at the SME (c1∗ , c2∗ ).
If (c1∗ , c2∗ ) was in the interior of the feasible set it would mean that we
are throwing away goods → not consistent with utility maximization.
If (c1∗ , c2∗ ) was outside the feasible set, it would mean that people are
consuming more goods than exist → impossible.
Therefor the equilibrium consumption bundle (c1∗ , c2∗ ) must lie on the
edge of the feasible set, i.e., the feasible set line must pass through
(c1∗ , c2∗ ).

setline
Y Feasible
A
Iztao
GA
i
g
t
T ul
budget
i
GA
Cf Y ytz.ae C
Now, because (c1∗ , c2∗ ) represents the highest possible utility affordable
to the individual, the consumption bundle (c1∗ , c2∗ ) is located where
the highest possible indifference curve U 0 is tangent to the budget
line.
The absolute slope of the budget line is z1 .
The absolute slope of the feasible set line is 1.

1
Since z < 1 the budget line is flatter than the feasible set line.
Given that the feasible set line is going through (c1∗ , c2∗ ) but at a
different slope it cannot also be tangent to indifference curve U 0 but
must intersect it.
This means that in the feasible set there are points of higher utility
for future generations that the SME (c1∗ , c2∗ ).
For example, point A on indifference curve U 1 is preferred by future
generations because it lies on a higher indifference curve.
Furthermore, because it offers more c2 than the SME (c1∗ , c2∗ ), it is

also preferred by the initial old over the SME.
Since future generations preferred point A why didn’t they choose it?
Reason: they could not afford it! Point A is not in their budget set.
The rate of return to money is too low for future generations to be

able to consume at point A.
If individuals were to consume c1A their money holdings would be too

small to afford c2A .
Given the policy of monetary expansion the SME is the best

individuals could do.
OLG model with fixed money supply:

I no expansion of money: z = 1
I no transfers to old: a = 0
There the budget line was identical to the feasible set line.
Future generations were able to choose A that maximized their utility.
Future generations prefer the SME without an expanding money

supply.

Welfare Cost of Inflation
Inflation caused by money expansion does not destroy goods:

individuals still consume on the edge of the feasible set.
But, they consume a different combination of (c1 , c2 ) with inflation

than without it.
I they choose to consume less of c2 (market good for which they need to
use money) and more of c1 (the endowment good), because of money’s
low rate of return.
The inflation tax, induces future generations to reduce their real

demand for money (y − c1 ) to a level below the optimum.
The resulting drop in money demand reduces the value of the initial
money holdings of the initial old, reducing their utility too.

Cost of Inflation
People are induced by fiat money’s low rate of return to consume

needlessly less of goods that require the use of money (like c2 ) in favour of
those that do not (like c1 ).

Generally
Inflation causes people to economize needlessly on the benefits offered

by the use of money to conduct transactions: inflation will reduce
welfare whenever money offers benefits to those who use it and
people face a non-trivial choice of how much money to hold.
The larger z, i.e., the flatter the budget line, the worse off individuals
are because the farther away they are from the Golden Rule.

3. Growth in Demand and Supply for Money

Environment
With money supply expansion, allow now for a growing population, to

analyze economy where fiat money supply and demand change at the
same time.
Population growth, with n > 1 in each t,
Nt = nNt−1
The stock of money in the economy grows at the gross rate

(constant) rate z > 1,
Mt = zMt−1

Environment
Increases in the stock of fiat money finance a lump-sum gift (in real
terms) of at to each old person in period t.
The newly printed dollars in each period t are given by,

Mt 1
Mt − Mt−1 = Mt − = 1− Mt
z z
Government budget constraint at time t,

1
Nt−1 at = 1 − Mt vt
z

c1,t + vt · mt ≤ y
c2,t+1 ≤ vt+1 · mt + at+1

vt vt
c1,t + · c2,t+1 ≤ y + · at+1
vt+1 vt+1

Market Clearing
real supply of money = real demand for money

vt Mt = Nt (y − c1,t )

Deriving the rate of return
The value of a unit of fiat money in t,
Nt (y − c1,t )
vt =
Mt
similarly the value of a dollar in t + 1 is given by,

Nt+1 (y − c1,t+1 )
vt+1 =
Mt+1
Using the equations for vt and vt+1 we can compute the real rate of
return to money as,
Nt+1 (y −c1,t+1 )
vt+1 Mt+1
= Nt (y −c1,t )
vt
Mt

Using the assumption of stationary equilibrium (c1,t = c1 ) the real

rate of return to fiat money with a growing population and an
expanding money supply is,
vt+1 Mt Nt+1 n
= =
vt Mt+1 Nt z
The rate of return to money is constant and equal to the ratio of the
gross population growth rate n and the gross rate of fiat money
expansion z.
Implication: the higher z the lower the rate of return to money, and the
higher n the higher the rate of return to money.

The budget constraint in a S.M.E.
Individual lifetime budget constraint,

vt vt
c1,t + · c2,t+1 ≤ y + · at+1
vt+1 vt+1
Using the assumptions of stationary equilibrium (including that at = a

for all t) and the derived rate of return to money,
z z
c1 + c2 ≤ y + a
n n

Planner’s Problem: Feasible Set
Population growth will affect the feasible set.
However, printing money does not alter the amount of goods Nt y

available for distribution between the young and old.
The feasible set is exactly the same as in the basic OLG model,
Nt c1,t + Nt−1 c2,t ≤ Nt y

Stationary allocation for each generation t,

(
c1,t = c1
c2,t = c2
With a growing population Nt = nNt−1 for all t.
Stationary per capita feasibility constraint,

1
c1 + c2 ≤ y
n
The expansion of fiat money does nothing to alter what is feasible in
this economy: neither z nor a appear in the feasibility constraint.

Comparison of SME and GRA with population growth

The feasible set line intersects the budget line at the SME (c1∗ , c2∗ )
(point B).
If (c1∗ , c2∗ ) was in the interior of the feasible set it would mean that we
are throwing away goods → not consistent with utility maximization.
If (c1∗ , c2∗ ) was outside the feasible set, it would mean that people are
consuming more goods than exist → impossible.
Therefor the equilibrium consumption bundle (c1∗ , c2∗ ) must lie on the
edge of the feasible set, i.e., the feasible set line must pass through
(c1∗ , c2∗ ).

thE7
Ex
setline
slope of budget lines 2
hY Feasible Z
slope of Feasible set

line n
too A
GA l
t
q y
I
budget
i line
ga Cf Y Anza
c
Now, because (c1∗ , c2∗ ) represents the highest possible utility affordable
to the individual, the consumption bundle (c1∗ , c2∗ ) is located where
the highest possible indifference curve U 0 is tangent to the budget
line.
The absolute slope of the budget line is nz .
The absolute slope of the feasible set line is n.

n
Since z < n the budget line is flatter than the feasible set line.
must intersect it.
for future generations than B.
For example, point A on indifference curve U 1 is preferred by future
generations because it lies on a higher indifference curve.
Furthermore, because it offers more c2 than the SME (c1∗ , c2∗ ), it is

also preferred by the initial old over the SME.
Since future generations preferred point A why didn’t they choose it?
Reason: they could not afford it! Point A is not in their budget set.
The rate of return to money is too low for future generations to be

able to consume at point A.
If individuals were to consume c1A their money holdings would not be

enough to afford c2A .
Given the policy of monetary expansion B is the best individuals

could do.
4. Government Policy to
Fix the Price Level

Concept
When the population grows at rate n, the total endowment of the

economy grows at rate n.
This implies that the value of money vt will also grow at rate n, when
the money stock is fixed → the price level pt falls.
Policy suggestion: if the economy is growing then the money supply

should grow at the same rate in order to keep the value of money
constant.

Thinking of the policy suggestion
Examine policy suggestion in two steps:
1 What rate of fiat money creation will maintain constant prices?
2 Will such a policy make individuals better off?

What rate will keep prices constant?
Recall that the rate of return to money with population growth and
money supply growth is,
vt+1 n
=
vt z
To keep the value of money constant vt+1 = vt and thus the price
level constant pt+1 = pt , the rate of increase in the numerator
(expansion in demand for money) must be equal to the rate of
increase in the denominator (expansion in the supply of money).
In other words, the rate of expansion of the stock of fiat money must
be equal to the rate of growth of money demand, i.e., the population
growth rate,
n=z

Is this policy desirable?
Compare the monetary equilibrium with z = n to the feasible set

when n > 1 → compare the lifetime budget constraint to the resource
constraint.
Lifetime budget constraint in a SME with z > 1 and n > 1,

z z
c1 + c2 ≤ y + a
n n
Lifetime budget constraint in a SME with z = n > 1,
c1 + c2 ≤ y + a
Feasible set with n > 1,

1
c1 + c2 ≤ y
n

Comparison of SME that fixes prices and GRA
To compare the stationary monetary equilibrium (SME) that fixes the

price level (z = n) and the Golden Rule Allocation (GRA) put them
on the same graph.
The feasible set line intersects the budget line at the SME (c1∗ , c2∗ ).
The SME is inefficient.
There are many points like A that everyone prefers over the SME.
I future generations prefer point A because it lies on a higher indifference
curve
I the initial old prefer it because it gives them more c2

With z n
when the
G x s M E govt
setline Fixes price level
my Feasible
slope of budget line 1
slope of Feasible set line

n
4 tao A
GA l
t
q y u
1
I
budget
I live
GA
Cf Y Ita c
What is wrong with the policy of setting z = n?
When the price level is fixed, an individual’s budget set line has slope
of −1, i.e., if the individual consumes one less good today, they will
receive one more good next period → the budget line tells individuals
that goods are equally available in every period.
... but this is not the true state of the economy, because the economy
is growing.
Therefore, if in each generation young people consume one less good

when young there will be n extra goods available for old people in
each generation → the economy can provide n goods for old people
for each single good not consumed by young people → the feasible
set line has a slope of −n.

What is wrong with the policy of setting z = n?
The message that the economy can offer n goods to the old for each
good not consumed by the young is not conveyed through the budget
set if prices are constant over time → prices are not allowed to reflect
reality.
Because the rate of return on money is 1, people see instead that

giving up one good when young will get them only one good when
old.
At the SME people consume more when young (higher c1 ) and less
when old (lower c2 ) than at the best feasible allocation A.

Golden Rule Monetary Policy
How can we convey to individuals the message of the extra availability of
goods for the old?
The budget line faced by individuals must be identical to the feasible
set line.
We know that they are the same when there is no expansion of the
fiat money stock → in this case the rate of return will be vt+1
vt = n →
signals to people the true state of the economy.
For each good not consumed by the young, an old person can
consume n goods.
Budget set = feasible set → people choosing the highest utility they
can afford are also the point of highest feasible utility.
Golden Rule Monetary Policy: not to maintain a fixed price level but
to maintain a fixed stock of fiat money, whatever the growth rate of
the economy.
5. Financing Government Purchases

Seignorage
The government can print new money costlessly.
A government that needs to raise revenue for government purchases

can print new units of fiat money.
Seignorage: the use of money creation as a revenue device.
What are the welfare effects of this policy?

Growing Supply of Fiat Money
Constant population, Nt = N for all t.
Money supply grows at the constant (exogenous) rate z > 1 each

period t,
Mt = zMt−1
z = gross rate of money supply expansion.
The newly printed dollars in each period t are given by,

Mt 1
Mt − Mt−1 = Mt − = 1− Mt
z z

Government Purchases
The newly printed money now is used to finance the government’s
acquisition of goods, i.e., government purchases Gt (not subsidies).
Assume that government purchases Gt are used in such a way as to
not affect an individual’s consumption bundle choice.
I e.g., foreign aid or defense expenditures, which have no effect on the
relative desirability of c1 and c2 .
I Reason: to study the effects of acquiring revenue for the government in
isolation from the benefits of government purchases.
Government budget constraint when revenue from printing money is

used for buying goods by the government,

1
Gt = 1 − Mt vt
z
Denote government purchases per old person as,
Gt
g=
Nt−1
First, consider the problem of an individual.
c1,t + vt · mt ≤ y
c2,t+1 ≤ vt+1 · mt

vt
c1,t + · c2,t+1 ≤ y
vt+1
Note: no subsidy now.

Market Clearing
real supply of money = real demand for money

vt Mt = Nt (y − c1,t )

Deriving the rate of return
The value of a unit of fiat money in t,
Nt (y − c1,t )
vt =
Mt
similarly the value of a dollar in t + 1 is given by,

Nt+1 (y − c1,t+1 )
vt+1 =
Mt+1
Using the equations for vt and vt+1 we can compute the real rate of
return to money as,
Nt+1 (y −c1,t+1 )
vt+1 Mt+1
= Nt (y −c1,t )
vt
Mt

Using the assumption of stationary equilibrium (c1,t = c1 ) and

constant population, the real rate of return to fiat money with an
expanding money supply is,
vt+1 Mt 1
= =
vt Mt+1 z
The rate of return to money is constant and equal to the inverse of

the gross rate of fiat money expansion z.
Inflation,
pt+1
=z
pt

Stationary Monetary Equilibrium
With Revenue
Seigniorage
Ga
slope of budget line

I
L
a 4
y
5 M E Ccf G
Implications
The higher z the lower the rate of return to money, and the higher
the inflation rate.
The value of existing money declines when new money is created in a

non-growing economy.
Reason: money creation causes inflation because an increasing the

number of dollars bid for the same number of goods.

Effects from an increase in z
1 The slope of the budget line has been made flatter.

I An individual must give up more of c1 to get one unit of c2 , in the
presence of inflation, because money has a lower rate of return.
2 The budget set has shrunk: it lies inside the budget set without
inflation.
I Reason: the goods acquired by the expansion of the money stock are
now being used up by the government instead of returned to
individuals as a subsidy.

misteintorage
E µ
with orage
sei gr
Is inflation an efficient tax?
Is the S.M.E. optimal?
Find the feasible set to see if any feasible allocations are preferred to
the monetary equilibrium (c1∗ , c2∗ ).
Feasible set: the total resources available in the economy cannot be

exceeded by the goods used up.
Note: you have to include the goods used up by the government, so

that we compare the utility of individuals given the same level of
government purchases Gt .

Planner’s Problem: Feasible Set
Population growth will affect the feasible set.
However, printing money does not alter the amount of goods Nt y

available for distribution between the young and old.

The feasible set with government purchases,
Nt c1,t + Nt−1 c2,t + Gt ≤ Nt y
Under a stationary allocation,

Nt−1 Gt
c1 + c2 + ≤y
Nt Nt
With a constant population, the stationary per capita feasibility

constraint is,
1
c1 + c2 + g ≤ y
n

Graph the Feasibility constraint
c t Cz E y g
E if Cz o c y g
i f C o g y g
slope I
y g 4
Comparison of SME and GRA with government purchases

The feasible set line intersects the budget line at the SME (c1∗ , c2∗ )
(point B) → the equilibrium consumption bundle lies on the edge of
the feasible set.
I after the government has taken its share, no consumer will choose to
throw away goods.
1
The absolute slope of the budget line is z while that of the feasible
set line 1 > z1 → budget line is flatter.

Efficiencyofs.ME
must intersect it.
for future generations than B.
Point A on indifference curve U 1 is preferred by future generations

because it lies on a higher indifference curve; and by the initial old
because it provides more c2 .
Therefore, the S.M.E. is not optimal, since A makes everyone better

off.

A Non-Distorting Tax
Can we get a budget set of a monetary equilibrium that reflects the

feasible set with g and makes A attainable?
Yes!
Consider a fixed tax of τ goods levied on every old person.

I this is a lump-sum tax: the amount paid to the government is not
affected by any actions the individual may undertake.

Consider the problem of an individual.
c1,t + vt · mt ≤ y
c2,t+1 ≤ vt+1 · mt − τ

vt vt
c1,t + · c2,t+1 ≤ y − τ
vt+1 vt+1

S.M.E. with lump-sum tax
Assume the entire amount of government purchases is raised through

lump-sum taxation,
τ =g
i.e., the government runs a balanced budget.
Then the money supply can be held constant,
Mt = M
Real rate of return to money in a stationary equilibrium with constant

population and constant money supply,
Nt+1 (y −c1,t+1 )
vt+1 Mt+1
= Nt (y −c1,t )
=1
vt
Mt

Given that the government runs a balanced budget τ = g the budget

set of the individual is,
c1 + c2 = y − g
Note: this is identical to the per capita feasibility constraint → point

A of maximum feasible utility for future generations can be attained.
Message: using lump-sum taxes the government raised the desired

revenue with no distortion of the budget set, i.e., without inducing
people to reduce their money balances in an effort to avoid inflation’s
implicit tax on those money balances.

With lump-sum taxation the demand for fiat money is greater than
when revenue is raised through inflation → greater real value of the
money balances owned by the initial old → improvement of welfare of
initial old.
Money creation is inferior to lump-sum taxation as a revenue device.
In fact, any tax on economic activity, unless that activity is

undesirable, is inferior to a lump-sum tax because it reduces the
incentive to undertake that activity.
Given that we do not see lump-sum taxes in the real world, seignorage
may just be one of many imperfect taxes.

Sample multiple choice questions:
1. When the government expands the money supply ar rate z and gives the new money to the
old as transfers at , the feasibility constraint is:
(a) c1,t Nt + (c2,t Nt−1 + at ) ≤ Nt y
(b) c1,t Nt + c2,t Nt−1 ≤ Nt y + zMt
(c) c1,t Nt + c2,t Nt−1 ≤ Nt y
(d) c1,t Nt + (c2,t + at ) Nt−1 ≤ Nt y + zMt
2. The real rate of return to money in a stationary monetary equilibrium with population growth
and expanding money supply is:
vt+1
(a) vt
= z1 .
vt+1
(b) vt
= nz .
vt+1
(c) vt
= nz .
vt+1
(d) vt
= n · z.
Answers: 1(c); 2(b).

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Monetary Economics II: Theory and Policy

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 1 / 60

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 2 / 60

Constant population, Nt = N for all t.

Money supply grows at the constant (exogenous) rate z > 1 each

z = gross rate of money supply expansion.

Real subsidy per old person in t,

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 3 / 60

Budget constraint in first period of life (real),

Budget constraint in second period of life (real),

c2,t+1 ≤ vt+1 · mt + at+1

Lifetime budget constraint (real),

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 4 / 60

Using the assumptions of stationary equilibrium (c1,t = c1 ) and

The rate of return to money is constant and equal to the inverse of

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 5 / 60

Individual lifetime budget constraint,

Using the assumptions of stationary equilibrium (including that at = a

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 6 / 60

The value lost to the “inflation tax” is proportional to the amount of

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 7 / 60

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 8 / 60

Is the expansion of the money stock optimal?

Compare budget set to feasible set,

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 9 / 60

The government’s expansion of fiat money does not have an effect on

Nt c1,t + Nt−1 c2,t ≤ Nt y

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 10 / 60

Stationary allocation for each generation t,

Constant population Nt = N for all t.

Stationary per capita feasibility constraint,

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 11 / 60

To compare the stationary monetary equilibrium (SME) and the

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 12 / 60

The absolute slope of the budget line is z1 .

The absolute slope of the feasible set line is 1.

Furthermore, because it offers more c2 than the SME (c1∗ , c2∗ ), it is

The rate of return to money is too low for future generations to be

If individuals were to consume c1A their money holdings would be too

Given the policy of monetary expansion the SME is the best

OLG model with fixed money supply:

Future generations were able to choose A that maximized their utility.

Future generations prefer the SME without an expanding money

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 15 / 60

Inflation caused by money expansion does not destroy goods:

But, they consume a different combination of (c1 , c2 ) with inflation

The inflation tax, induces future generations to reduce their real

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 16 / 60

People are induced by fiat money’s low rate of return to consume

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 17 / 60

Inflation causes people to economize needlessly on the benefits offered

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 18 / 60

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 19 / 60

With money supply expansion, allow now for a growing population, to

Population growth, with n > 1 in each t,

The stock of money in the economy grows at the gross rate

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 20 / 60

The newly printed dollars in each period t are given by,

Government budget constraint at time t,

ECON3440C - Adamopoulos Monetary Economics, Lecture 5 2021 21 / 60

Budget constraint in first period of life (real),

Budget constraint in second period of life (real),