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 2
ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 1 / 46

1. Overlapping Generations Model:
Recap

Recap
Individuals live for two periods,

I in the first period they are young
I in the second period they are old.
Time is discrete, indexed by t, and begins at t = 1.
In each period Nt individuals are born.
In period t = 1 there are N0 initial old.

Recap
In each period t there are two types of individuals alive,

I Nt young (born in period t)
I Nt−1 old (born in period t − 1)
Single, non-storable good each period. Each individual receives an
endowment of the single consumption good,

(
y , when young.
0, when old.

Overlapping structure of Cohorts
N3 Young Nz old
Nz Young
N young N old
t I t z t 3 t 4
Recap
Members of future generations care about bundles (c1,t , c2,t+1 ) over

their lifetime.
Preferences are captured by utility function U (c1,t , c2,t+1 ), and

represented graphically by indifference curves, with standard
properties.
Initial old care only about their consumption in period t = 1.

Economic Problem facing Future Generations
period t period ttl
Endowment
0
Pattern y
consumption c t cz.tt
Pattern
Examine two Solutions
Centralized Solution: a benevolent planner with perfect information

allocates the economy’s resources between the young and old alive in
each period.
Decentralized Solution: individuals can use money to trade for what

they want.
Compare the two solutions in terms of welfare.

Planner’s Problem

Feasible Allocations
Central planner has complete knowledge and total control over the
economy.
Planner’s job: allocate available goods among young and old in each
period t.
The constraint on the planner’s problem is called a a feasibility

constraint or resource constraint.

Feasibility Constraint
Tells us the combinations of consumption of the young and old that

are feasible for the economy as a whole.
At any given point in time the planner cannot allocate more goods to
the current young and old than are available in the economy.
At each point in time only the young have goods (endowments).

Total amount of the consumption good available in period t,
Nt · y + Nt−1 · 0 = Nt · y
Suppose every member of generation t gets the same bundle

(c1,t , c2,t+1 ).
Total consumption of young in period t,
Nt · c1,t
Total consumption of old in period t,

Nt−1 · c2,t
Total consumption of young and old in period t,
Nt · c1,t + Nt−1 · c2,t
Per Capita Feasibility Constraint
Constraint of central planner,
Nt · c1,t + Nt−1 · c2,t ≤ Nt · y
Simplifying Assumption: population is constant Nt = N for all t.
Then we can re-write the the constraint as,
N · c1,t + N · c2,t ≤ N · y
or
c1,t + c2,t ≤ y
which is the per capita feasibility constraint.

Stationary Feasibility Constraint
Focus on a stationary allocation, that gives the members of each

cohort the same lifetime consumption pattern, i.e., for each period
t = 1, 2, 3, ..., (
c1,t = c1
c2,t+1 = c2
Then the stationary per capita feasibility constraint is,
c1 + c2 ≤ y

Stationary per capita feasibility
constraint c t E E Y
graph it
For c o
Cz y
For Cz o c
y
slope I
do
OF
boundary set
set
line feasible
Y feasible
set
i
I
ferdofffft
y
Golden Rule Allocation (GRA)
Efficiency benchmark relative to which we will compare the

decentralized solutions.
Problem of Planner: maximize the utility of representative individual

of future generations s.t. to what is feasible.
Solution to planners problem ⇒ Golden Rule Allocation (c1∗ , c2∗ )
Show the Golden Rule Allocation graphically.
Solution (c1∗ , c2∗ ) is unique here.

Golden Rule Allocation
cci.ci
CLA
B D
it 3
at 9
What about the initial old?
The GRA maximizes the utility of future generations but it does not
maximize the utility of the initial old.
The initial old only care about the consumption in the only period
they are around t = 1, which is the second period of life.
So an allocation that maximizes the initial old welfare would call for
highest possible c2 .
Among stationary feasible allocations this would be accomplished at

cb2 = y , i.e., at point E.
Note: E does not maximize the welfare of future generations, they

prefer the more balanced combo (c1∗ , c2∗ ).
But infinite number of future generations and only one initial old
generation.
3. Recap

Recap
Economy goes on forever, but individuals live for two periods in an

overlapping fashion.
In each period t there are two types of individuals alive,

I Nt young (born in period t)
I Nt−1 old (born in period t − 1)
Each individual receives an endowment,

(
y , when young.
0, when old.
Members of future generations care about bundles (c1,t , c2,t+1 ) over

their lifetime.

Centralized Solution
A benevolent planner with perfect information and total control

allocates the economy’s resources between the young and old alive in
each period.
The constraint on the planner’s problem is called a a feasibility

constraint or resource constraint.

Nt · c1,t + Nt−1 · c2,t ≤ Nt · y
Simplifying Assumption: population is constant Nt = N for all t.
Focus on a stationary allocation, that gives the members of each

cohort the same lifetime consumption pattern, i.e., for each period
t = 1, 2, 3, ..., (
c1,t = c1
c2,t+1 = c2
Then this gives you the stationary per capita feasibility constraint
c1 + c2 ≤ y

Golden Rule Allocation (GRA)
Efficiency benchmark relative to which we will compare the

decentralized solutions.
Problem of Planner: maximize the utility of representative individual

of future generations s.t. to what is feasible.
Solution to planners problem ⇒ Golden Rule Allocation (c1∗ , c2∗ )
Show the Golden Rule Allocation graphically.
Solution (c1∗ , c2∗ ) is unique here.

Overlapping structure of Cohorts
N3 Young Nz old
Nz Young
N young N old
t I t z t 3 t 4
Decentralized Solutions

Decentralized Solutions
Implementing the GRA requires the planner taking away c2∗ from
every young individual and giving it to every old individual.
Strong assumptions associated with the power and wisdom of the

planner to implement the GRA,
I planner has ability to reallocate endowments costlessly
I to determine c1∗ , c2∗ the planner must know exactly the utility function
of individuals
Can the GRA be achieved in a decentralized manner, by which

individuals engage willfully in mutually beneficial trades, i.e., through
the market?
Define what we mean by a decentralized setting or competitive

equilibrium.

Competitive Equilibria
Individuals are self-interested, i.e., they seek to maximize their own

utility.
Individuals are price-takers, i.e., they act as if they cannot affect rates
of exchange.
Markets clear, i.e., prices adjust to equate supply and demand in all
markets.

Competitive Equilibrium Without Money
Individuals are endowed with (y , 0).
Given assumptions about preferences their utility can increase if they

↓ c1 and ↑ c2 .
Are there trades that can achieve this outcome?

No!
Who are the people around that a young person at time t can
potentially trade with?
I Other young people of the same generation t.
I Old people of previous generation t − 1.
But trade with other young would not be beneficial because they are
all trying to get goods for next period.
Trade with the current old will also not be beneficial because the old
want the good of the young but they do not have goods tomorrow,
which is what the young are looking for.

The only people who have what the current young are looking for
(goods in t + 1) are the young of generation t + 1, i.e., the next
generation.
... but the next generation young have no interest in trading with the
current young of generation t because they are not alive yet in t.
The lack of possible trades across generations in the OLG model

captures the absence of “double coincidence of wants.”
People cannot trade because they are separated in time: incomplete

markets.

Autarkic Equilibrium
So individuals have no economic interaction with each other, and as a

result just consume what they have (their endowment),
(
c1 = y
c2 = 0
The competitive equilibrium in this economy is an autarkic

equilibrium.
In this equilibrium utility for future generations is low, and certainly

lower than the GRA, i.e., this “market” equilibrium is inefficient.
Initial old are also worse off, because with the GRA they get positive
consumption, while here nothing.

Introduction of Money
To open up a trading opportunity we introduce fiat money in the

economy.
Here we will assume that fiat money,

I is pieces of paper
I can be costlessly produced by the government
I it cannot be counterfeited
I it can be costlessly held over time
I distinctively marked (recognizable)

Introduction of Money
Assume that the stock of fiat money supplied by the government is

fixed and equal to M.
Assume that money is introduced as a gift or subsidy to the initial old

of an amount per old,
M M
=
N0 N

Monetary Equilibrium
A monetary equilibrium is a competitive equilibrium in which there is

a valued supply of fiat money.
“valued” = fiat money can traded for some of the consumption good,
i.e., people are willing to give up some of the consumption good in
exchange for money.

Trading Opportunity
Introducing fiat money potentially opens a trading opportunity:
A young person can sell some of his endowment to the old in exchange for
money, carry the money over to the next period, and use it to buy goods
from the young next period.

Finding the demand for fiat money
Trading opportunity exists only if fiat money is valued

(people are willing to give up some of the consumption good for
money and vice versa).
Since fiat money is intrinsically useless its value depends on the view
of its future value.
If people believe that fiat money will not be valued next period then it
will not be valued today.
Similarly, fiat money will have no value today if it is known that it will
be valueless in some future period T .
Consider the equilibrium where fiat money has a positive value in all
future periods.

Finding the demand for fiat money
Call our unit of fiat money a dollar.
Define by pt the dollar price of the consumption good (price level).
Define by vt = p1t the value of $1 in terms of the consumption good.

(how many goods can you buy with one dollar)

An individual’s budget
How much money will individuals want to hold (demand)?
Establish (budget) constraints on the consumption choices of

individuals.
In the first period, the individual with y goods (endowment) has two
options:
1 consume goods
2 sell them for money
Since future generations have no money they can acquire it only

through trades.
Let mt be the number of dollars acquired by an individual in exchange

for the consumption good in time t (nominal demand for money).

First Period Budget Constraint
Budget constraint in first period of life of an individual,
pt · c1,t + mt ≤ pt · y
Note: this budget constraint is in dollars (nominal).
pt · c1,t = dollar value of first period consumption
mt = dollars acquired by selling goods

(demand for nominal money balances)
pt · y = dollar value of individual’s endowment.

First Period Budget Constraint
To get the budget constraint in real terms divide through by pt ,

1
c1,t + · mt ≤ y
pt
or
c1,t + vt · mt ≤ y
c1,t = number of good consumed
vt · mt = number of goods sold

(demand for real money balances)
y = total endowment (source of goods).

Second Period Budget Constraint
Individual receives no endowment.
When old you can acquire goods for consumption only through
spending money acquired when young.
The dollar value of what you consume cannot exceed the money you
have.

Budget constraint for individual in second period of life,
pt+1 · c2,t+1 ≤ mt
pt+1 · c2,t+1 = price × amount of consumption in t + 1
mt = money acquired in period t

To get the budget constraint in real terms divide through by pt+1 ,

1
c2,t+1 ≤ · mt
pt+1
or
c2,t+1 ≤ vt+1 · mt

Individual’s Lifetime Budget Constraint
Substitute the second period constraint into the first period constraint for
mt ,
vt
c1,t + · c2,t+1 ≤ y
vt+1
tells us all the combinations of first and second period consumption

that an individual can afford over their lifetime.
vt+1
vt = (gross) real rate of return to money: how many goods can be
obtained in period t + 1 if one unit of the good is sold for money in
period t.

Problem of the individual
max U (c1,t , c2,t+1 )

{c1,t ,c2,t+1 }
s.t.
vt
c1,t + · c2,t+1 ≤ y
vt+1
Maximize lifetime utility (objective), subject to lifetime budget

constraint (constraint).

lifetime budget constraint
Graph
For Czet O at y horizontal intercept
For Cit o Get Vt vertical intercept
d Cz
ii
V real rate of return

Why is the
give up 1 unit of cons good int to get

Pt Te
in Ets with 1 you can
buy Vtt goods
but with 404 car buy Vtm good

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 2 2021 1 / 46

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 2 / 46

Individuals live for two periods,

Time is discrete, indexed by t, and begins at t = 1.

In each period Nt individuals are born.

In period t = 1 there are N0 initial old.

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 3 / 46

In each period t there are two types of individuals alive,

Single, non-storable good each period. Each individual receives an

endowment of the single consumption good,

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 4 / 46

Members of future generations care about bundles (c1,t , c2,t+1 ) over

Preferences are captured by utility function U (c1,t , c2,t+1 ), and

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 5 / 46

period t period ttl

Centralized Solution: a benevolent planner with perfect information

Decentralized Solution: individuals can use money to trade for what

Compare the two solutions in terms of welfare.

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 6 / 46

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 7 / 46

The constraint on the planner’s problem is called a a feasibility

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 8 / 46

Tells us the combinations of consumption of the young and old that

At each point in time only the young have goods (endowments).

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 9 / 46

Suppose every member of generation t gets the same bundle

Total consumption of old in period t,

Constraint of central planner,

Nt · c1,t + Nt−1 · c2,t ≤ Nt · y

Simplifying Assumption: population is constant Nt = N for all t.

Then we can re-write the the constraint as,

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 11 / 46

Focus on a stationary allocation, that gives the members of each

Then the stationary per capita feasibility constraint is,

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 12 / 46

Efficiency benchmark relative to which we will compare the

Problem of Planner: maximize the utility of representative individual

Solution to planners problem ⇒ Golden Rule Allocation (c1∗ , c2∗ )

Show the Golden Rule Allocation graphically.

Solution (c1∗ , c2∗ ) is unique here.

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 13 / 46

Among stationary feasible allocations this would be accomplished at

Note: E does not maximize the welfare of future generations, they

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 15 / 46

Economy goes on forever, but individuals live for two periods in an

In each period t there are two types of individuals alive,

Each individual receives an endowment,

Members of future generations care about bundles (c1,t , c2,t+1 ) over

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 16 / 46

A benevolent planner with perfect information and total control

The constraint on the planner’s problem is called a a feasibility

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 17 / 46

Nt · c1,t + Nt−1 · c2,t ≤ Nt · y

Simplifying Assumption: population is constant Nt = N for all t.

Focus on a stationary allocation, that gives the members of each

ECON3440C - Adamopoulos Monetary Economics, Lecture 2 2021 18 / 46

Efficiency benchmark relative to which we will compare the

Problem of Planner: maximize the utility of representative individual

Solution to planners problem ⇒ Golden Rule Allocation (c1∗ , c2∗ )

Show the Golden Rule Allocation graphically.

Solution (c1∗ , c2∗ ) is unique here.