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

Monetary Economics II: Theory and Policy
ECON 3440C
Tasso Adamopoulos
York University
Fall 2021
Lecture 8
ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 1 / 49

1. The Lucas Model

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

markets).
Half (1/2) of the old individuals in any period live on each of the two
islands (random assignment).
The young are unequally distributed across the two islands,

I 2/3 of the young live on one island
I 1/3 of the young live on the other island
Fiat money grows at the time-varying rate zt (random variable)
Mt = zt Mt−1
Individuals only observe price on their island pti .

N old N old
I
3N young f N
young
Individual budget constraints
Individual budget constraint when young in period t on island i,

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

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

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

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

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

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

2. Non-random inflation
in the Lucas Model

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

inflation).
Market clearing condition for fiat money in terms of goods,

Mt
N i ` pti = vti

2
We can then solve implicitly for the price level on island i,
Mt /2
pti =
N i ` pti

Therefore, observing the price of goods pti allows all of the young to
infer the number of young on their island.

Implied prices
Define prices,
I ptA = price of goods when population of young is small, N A = 31 N
I ptB = price of goods when population of young is large, N B = 32 N
Then,
Mt /2 M /2
ptA = = 1 t A
N A ` ptA 3 N` pt
Mt /2 Mt /2
ptB = = 2
N ` ptB
B

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

Outcomes on each island
The price of goods is driven by the scarcity of young people producing

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

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

low, and each young produces little.

Effect of money increases on output
Real rate of return to work,

Mt /2

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

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

by the same proportion and so fails to affect the relative price of
goods in this period and the next → money is neutral .
With Mt+1 = zMt as ↑ z we have ↓ MMt+1 t

= z1 and thus from the rate
of return equation, the real rate of return to work falls → discourages
work because money balances earned from work are taxed by the
expansion of the money supply → fall in aggregate output.

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

total
inflation output across labour
economies with different supply
constant Z's
equivalent
to aggregate
output
3. Random monetary policy
in the Lucas Model

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

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

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

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

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

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

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

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

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

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

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

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

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

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

young and another with a small population of young.

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

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

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

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

4. Lucas Critique

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

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

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

Suppose the government unexpectedly increases the money stock

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

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

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

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

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

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

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

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

as
FL
time
to ti
time over which

individual confused
o.gg
9afe
7
time
to
Change in policy regime
To see this, suppose that the government decided to unexpectedly

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

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

Why does this happen?
Because the positive correlation between inflation and output we see

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

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

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

individuals can do is to reduce output.

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

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

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

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

5. The Government Budget Constraint

Government Borrowing
Up to now we left government borrowing out of the analysis, but in

reality governments often finance current deficits by borrowing →
issue bonds → raises national debt.
What is the effect of national debt on government revenues and

expenditures?
What is the effect of national debt on monetary policy?
Extend the government budget constraint to include bonds.
Bonds affect the government budget constraint in two ways:

I When issued: provide a source of revenue for the government.
I When retired with interest: bonds represent an expenditure for the
government.

Environment
Each government bond is worth one unit of the consumption good.
One-period maturity: a government bond issued at time t matures

and is retired at t + 1, at which time the government re-pays principal
of loan and interest.
Assume that both bonds and money are held.
bt = number of bonds issued in t per young person
r = gross real rate of return on bonds (principal + interest)
τt = taxes collected by the government, per young person.
g = government purchases per young person, expressed in units of

the consumption good.

Government Revenues and Expenditures
Sources of government revenue:

I bond issue: Nt bt
I seignorage from printing new money: (Mt − Mt−1 ) vt
I tax collections: Nt τt
Total government revenue = Nt bt + Nt τt + (Mt − Mt−1 ) vt .
Sources of government expenditure:

I government purchases of consumption goods: Nt g
I interest on previously issued debt: rNt−1 bt−1 (in t − 1 the government
issues bonds Nt−1 bt−1 ; bonds mature in period t; government must
pay back principal plus interest, with a total expenditure to retire the
t − 1 bonds of rNt−1 bt−1 ).
Total government expenditure = Nt g + rNt−1 bt−1

Government Budget Constraint
total government expenditure = total government revenue

Nt g + rNt−1 bt−1 = Nt bt + Nt τt + (Mt − Mt−1 ) vt
Divide through by Nt ,
Nt−1 vt
g +rbt−1 = bt + τt + (Mt − Mt−1 )
Nt Nt
Money growth: Mt = zt Mt−1 .
Population growth: Nt = nNt−1
vt Mt
qt = Nt real value of money balances per young person in t.
The the per young person budget constraint is,

r 1
g + bt−1 = τt + bt + qt 1 −
n zt
The Government’s Intertemporal Choice
Loot at the government’s position at the beginning of the economy:
in period t = 1 the budget constraint is,

r 1
g + b0 = τ1 + b1 + q1 1 − (1)
n z1
r
n b0 represents initial debt of the government.
I
I b represents debt to be passed on to future generations.
1
To simplify the analysis assume that for t > 1 the government

maintains the debt per young person at b1 , i.e., bt = b1 = b.
Furthermore, the government pursues constant tax, τt = τ , and

seignorage policy, qt = q and zt = z
Future taxes and seignorage may differ from their present levels
(t = 1), but will not change after the first period, i.e., for t > 1.
The Government’s Intertemporal Choice
These assumptions will allow us to represent the future as a

stationary equilibrium, that can be easily compared to the present.
Then, for t > 1 the government budget constraint is,

r 1
g + b =τ +b+q 1− ⇒
n z

1 r
g =τ +q 1− +b 1− (2)
z n
The two budget constraints (1) and (2) are linked in that b1 in (1) is
the b in (2): bonds issued in period t = 1 are the bonds on which
interest must be paid in the future.

Effects of Changes in Government Spending Decisions
Suppose the government wishes to increase g in period t = 1,

without increasing taxes or the rate of money creation in period
t = 1. How can this be accomplished?
In (1) note that b0 is pre-determined from period t = 0 and is outside

the government’s control in period t = 1.
Here the government chooses not to increase τ1 or z1 ⇒

∆τ1 = ∆z1 = 0.
The only choice left is to increase b1 , i.e., issue bonds in period t = 1

to pay for the increased government expenditures ⇒ ∆b1 = ∆g .

Effects of Changes in Government Spending Decisions
However, the b1 in (1) is the b in (2), i.e., the increase in bond

issuance in period t = 1 affects the menu of options available to the
government in subsequent periods.
If r > n, the increase in b causes the RHS of (2) to fall, since

1 − nr < 0 in this case.
For the equality to be maintained in (2) either τ or z or both must

increase, i.e., if the government wanted to pursue the policy of
increasing g , either taxes or inflation must increase in the future.
The issuance of debt today will lead to a corresponding increase in

interest payments to service that debt in the future.

Lessons
Government decisions made today about spending, taxation,

borrowing, money creation affect the the options available to the
government in the future.
If the government decides to spend more today it cannot expect to

lower both taxes and inflation in the future → option not available if
r > n.
This statement is not an assessment: the government may have good

reason to run a deficit even if r > n, e.g., help an unlucky generation
because of a war, recession, crisis or it may wish to make a future
generation contribute to the funding of durable government projects,
like schools, highways that benefit more than one generation.

Lessons
The government budget constraint does not say that the government
should never run a deficit, just that if r > n lower taxes or seignorage
today imply higher taxes or seignorage in the future → the
government cannot always run deficits, at some point those have to
turn into surpluses.
With bonds the government defers rather than solves the need to
raise revenue.

7. Savings and Investment

Big Picture
Take a more long-term view now.
Up to now we used the OLG model as a model of money: people

needed money to acquire the market good c2 .
We did not interpret c2 literally as consumption in old age because

money balances are a trivial component of retirement savings.
We used the OLG model to model exchange, without taking the age
structure seriously.
Now we will take the age structure of the OLG model seriously and
turn to the subject of the determinants of aggregate
savings/investment.
We focus on capital and government bonds because they constitute

important components of lifetime savings.
Savings Decisions
How do individuals choose their savings?
Standard two-period OLG model in which individuals choose how

much to consume when young and old, (c1,t , c2,t+1 ).
Each individual has endowment of y1 of the good when young

(“current income”), and y2 when old (“future income”).
The young face a gross real interest rate of r .
They choose how much to save st .

Cz
try
t4z
ENDOWMENT POINT
Yz
1
y Y 4
Note the endowment point CY Yz

lies on the budget line
because you can always choose
to just consume 4 4
and Cz 42 and have StEO
Budget Constraints
Budget constraint when young in period t,
c1,t + st ≤ y1
Budget constraint when old in period t + 1,
c2,t+1 ≤ y2 + r · st
Combine the two to get the lifetime budget constraint,

c2,t+1 y2
c1,t + ≤ y1 +
r r
Graph the lifetime budget constraint.

Individual Problem
Choose the optimal (c1,t , c2,t+1 , st ) to maximize lifetime utility

U (c1,t , c2,t+1 ) subject to the lifetime budget constraint, i.e., to attain
the highest possible utility the individual can afford.
This occurs where the highest possible indifference curve U 0 is

tangent to the budget line.
This gives optimal consumption in the two periods of life as (c1∗ , c2∗ ).
Then from the first period budget constraint we can solve for optimal
savings as,
s ∗ = y1 − c1∗
Savings can be negative, which would mean that you are borrowing
against your future income.

Note relative positions
Go of 994 depend on
individual preference
iif
ya f
1
c
Yi 4,1 42
r G
s I Y Cf
Wealth
If savings are zero, then individual consumption in each period is

determined only by current income in that period, i.e., if st = 0 then
c1 = y1 and c2 = y2 .
Saving allows an individual to choose a bundle (c1 , c2 ) constrained

only by wealth wt , defined as the present discounted value of lifetime
incomes,
y2
wt = y1 +
r
→ measure of lifetime income.
Note, wealth is not simply the sum of incomes in the two periods
y1 + y2 , but y2 is expressed in present value terms (divided by r ).

A SIDE ON PV
t one period ttt
x x r CFV or TV
Ir y Pv
with a one period loan
FV
pre D FV r PV
f
if loan over T periods duration

of loan
if single payment 1 periods
From today pv FI
T
if payments in each period

pv
FIL t
Fi FLIT
So
Sitt PV of second period cons
Yf PV of second period income
PV lifetime income
we y
tYz
with 3 periods
wt yet
42ft YI
r2
Wealth and Consumption
Then we can re-write the intercepts of the lifetime budget constraint

as w (horizontal intercept) and r · w (vertical intercept).
So (c1∗ , c2∗ ) will be entirely determined by w and r .
How does the consumption bundle (c1 , c2 ) respond to increase in wt ?
The breakdown of the extra wealth depends on the relative

preferences of consumers when young and old.
If the consumption of a good decreases when the wealth increases,

then the good is inferior.
However, (c1 , c2 ) are unlikely to be inferior goods, because they are

baskets of goods in each period.

Wealth and Consumption
We expect that an increase in w would increase both c1 and c2 , i.e.,

they are normal goods.
For a given w , the (c1 , c2 ) chosen does not depend on when that
wealth is received → a given w is consistent with many different
combinations of (y1 , y2 ) for given r .
In all these different cases only w matters not the allocation across y1
and y2 → same lifetime budget constraint.
Distinguish between income and wealth,

I income: goods an individual produces or receives in a single period.
I wealth: PV of individual lifetime income stream.
The above analysis suggests that it is wealth, not income, that

determines lifetime consumption choices.

efreafsoFl
Taxes and Consumption/Savings
Focus on lump-sum taxes in terms of goods (real terms): τ1 on each

young, and τ2 on each old.
Budget constraint when young,
c1,t + st ≤ y1 − τ1
Budget constraint when old in period t + 1,
c2,t+1 ≤ y2 + r · st − τ2
Combine the two to get the lifetime budget constraint,

c2,t+1 y2 − τ2
c1,t + ≤ y1 − τ1 +
r r
RHS → PV of individual after-tax endowments.

Cy
Yz z I
Y 7 Yi 2 t 4
Cf we
9
S
Wealth Neutral Tax Changes
Consider changes in taxes (τ1 , τ2 ) that do not affect an individual
taxpayer’s wealth.
Initial taxes on the young and old: (τ1∗ , τ2∗ ).

Tax policy change:
I increase taxes on the young by 10 goods to: τ1∗ + 10.
I decrease taxes on old by 10 · r : τ2∗ − 10r
Does this tax policy change affect the taxpayer’s wealth?
Substitute the new taxes in,

y2 − τ2 (y2 − τ2∗ + 10r )
w = y1 − τ1 + = (y1 − τ1∗ − 10) + =
r r
(y2 − τ2∗ )
= (y1 − τ1∗ ) + = w∗
r
→ no effect on after-tax wealth.
Wealth Neutral Tax Changes
Reason: in PV terms the ↓ τ2 exactly offsets the ↑ τ1 .
Since w is not affected the (c1∗ , c2∗ ) combination desired by the

individual is unaffected.
Message: here the PV of lifetime taxes matters only but not the
timing of those taxes.
How is this (c1∗ , c2∗ ) implemented? You reduce your st by 10 goods to

pay for the extra tax τ1 → you will be compensated in PV equivalent
terms by the future tax cut.

Wealth Effects
Tax policy change:

I ↑ τ1
I no change in τ2
What is the effect on consumption-saving?
Now the lifetime tax burden increases → taxpayer lifetime wealth falls
→ drop in lifetime consumption → drop in both c1 and c2 since both
normal goods.
What happens to savings?

I To reduce c2 the individual reduces their savings st → this way the
young split the reduction in income between c1 and st .

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

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Monetary Economics II: Theory and Policy

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 1 / 49

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 2 / 49

Standard OLG model of money.

Assumption: individuals live in two spatially separated island (distinct

The young are unequally distributed across the two islands,

Fiat money grows at the time-varying rate zt (random variable)

Individuals only observe price on their island pti .

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

where superscript i denotes island on which individual is born.

Labour is paid in money, mti = `it pti

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

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 4 / 49

Money holdings and lump-sum government transfers serve to finance

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

Second period consumption depends on island i where the individual

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 5 / 49

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 6 / 49

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

Market clearing condition for fiat money in terms of goods,

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 7 / 49

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 8 / 49

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

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

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

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 9 / 49

Real rate of return to work,

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

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

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 10 / 49

negative correlation between

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 11 / 49

Consider our single two-island economy again.

Now monetary policy is random, i.e., Mt =

The realization of monetary policy (realized value of zt ) is kept secret

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 12 / 49

Consider the market clearing condition N i ` pti = vti M2t , which

For example, a high price of goods pti may result from:

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 13 / 49

Whether it is one or the other is important for the young.

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 14 / 49

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 16 / 49

Unable to infer anything about N i on their island they “split the

This will result in an intermediate price level p ∗ which is higher than

This randomized monetary policy does not always increase output.

... in case b they produce less.

In an economy there is always one island with a large population of

ECON3440C - Adamopoulos Monetary Economics, Lecture 8 2021 18 / 49

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

In periods when zt = 1, one island will be at a and the other at b,

This results in a relationship similar to the Phillips curve: output is

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The higher expected z reduces the anticipated real rate of return to

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Suppose the government unexpectedly increases the money stock

The reason is that individuals are confused: individuals on the island

Thus, the unexpected increase in the money stock leads to higher

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

Then we would be tempted to infer that the government can increase

This policy would not work: although there is a statistical relationship