ECO612A: APPLIED

MACROECONOMICS

OLG-MODEL OF
MONEY DEMAND
WEEK 8

ECO612A: APPLIED MACROECONOMICS

• Reference Book and Reading Material:

• Modelling Monetary Economics (3rd Edition) by Bruce Champ, Scott Freeman and
Joseph Haslag

• Chapters 1 and 2

ECO612A: APPLIED MACROECONOMICS 2

Basic modelling environment
• We are talking about an Overlapping Generation (OLG) model in which individuals live for two
periods.
• People living in the first period are denominated as “Young”
• Second-period living people are called “Old”

• The economy begins in period 1. In each period, 𝑡 ≥ 1, 𝑁𝑡 individuals are born.

• In each period 𝑡, there are 𝑁𝑡 young individuals and 𝑁𝑡−1 old alive in the economy.
• For example, in period 1, there are 𝑁𝑂 old individuals and 𝑁1 young individuals born at
the beginning of period 1.
• There is only one good in the economy. The good cannot be stored from one period to
the next.
• The amount of this endowment is denoted as 𝑦 and no one receives endowment in the
second period.
Basic modelling environment

Period 1 2 3 4 5 6

Generation
Initial old Old

Young Old
1
Endowed None
Young Old
2
generations
Future

3 Young Old

4 Young Old

5 Young Old
Basic modelling environment
• Preferences are standard with the option of consuming the available
endowment.
• Standard utility function (IC) assumptions
• We denote the amount of the good that is consumed in the first period of life
by an individual born in period 𝑡 with the notation 𝑐1,𝑡 and 𝑐2,𝑡+1 denotes
the amount the same individual consumes in the second period of life.
• The preferences of the initial old are much easier to describe than those of
future generations.
• The initial old live and consume only in the initial period and thus want to
maximize their consumption in that period.
Problem Statement
• The problem facing future generations of this economy is very simple.
• They want to acquire goods they do not have!!
• Each has access to the non-storable consumption good only when young but wants to
consume in both periods of life.
• They must, therefore, find a way to acquire consumption in the second period of life and
then decide how much they will consume in each period of life.
 Possible solutions
• A centralized solution in which a social planner will allocate the economy’s
resources between consumption by the young and by the old.

• Decentralised solution: we allow individuals to use money to trade for what

they want.
Central planner solution
• Defining the budget constraints
• We know that only the young people are endowed with the consumption good at time 𝑡.
• There are 𝑁𝑡 of these young people at time 𝑡.
(𝑡𝑜𝑡𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑔𝑜𝑜𝑑)𝑡 = 𝑁𝑡 𝑦 (1)

• Suppose that every member of generation 𝑡 is given that same lifetime allocation (𝑐1,𝑡 ,
𝑐2,𝑡+1 ) of the consumption good
• Total consumption by the young people in period 𝑡 is:
(𝑡𝑜𝑡𝑎𝑙 𝑦𝑜𝑢𝑛𝑔 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛)𝑡 = 𝑁𝑡 𝑐1,𝑡 (2)

• Total consumption by the old people in period 𝑡 is:

(𝑡𝑜𝑡𝑎𝑙 𝑜𝑙𝑑 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛)𝑡 = 𝑁𝑡−1 𝑐2,𝑡 (3)
Central planner solution
• We are now ready to state the constraint facing us as central planners
• Total consumption by young and old cannot exceed the total amount of available
goods
𝑁𝑡 𝑐1,𝑡 + 𝑁𝑡−1 𝑐2,𝑡 ≤ 𝑁𝑡 𝑦 (4)
• We assume that the population is constant (𝑁𝑡 = 𝑁 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑡)
𝑁𝑡 𝑐1,𝑡 + 𝑁𝑡−1 𝑐2,𝑡 ≤ 𝑁𝑦
• Dividing through by N, we obtain the per capita form of the constraint facing us
as central planners: 𝑐1,𝑡 + 𝑐2,𝑡 ≤ 𝑦 (5)
Central planner solution: Stationary allocation
• A stationary allocation gives the members of every generation the same lifetime
consumption pattern.
• In other words, in a stationary allocation, 𝑐1,𝑡 = 𝑐1 and 𝑐2,𝑡 = 𝑐2 for every period 𝑡 =
1, 2, 3, and so on.
• However, it is important to realize that a stationary allocation does not necessarily imply
that 𝑐1 = 𝑐2 .
• With a stationary allocation, the per capita constraint becomes:
𝑐1 + 𝑐2 ≤ 𝑦 (6)
Central planner solution: Golden rule allocation
• The golden rule allocation is the stationary, feasible allocation of consumption
that maximizes the welfare of future generations.
• It is located at a point of tangency between the feasible set line and an
indifference curve.
• The golden rule allocation, point A allocates more goods to people when old
than when young (𝑐1 < 𝑐2 ).
• Feasible or optimal solution is the maximization of the utility of future
generations, an objective we call the “golden rule.”
Decentralised solutions: Basic premise
• In the decentralized solutions, one in which the economy reaches the optimal allocation
through mutually beneficial trades conducted by the individuals themselves.
• In other words, can we let a market do the work of the central planner?
• First, we discuss the notion of a competitive equilibrium.
• A “competitive equilibrium” has the following properties:
• Everyone makes mutually beneficial trades with other individuals. Through these trades, the
individual attempts to attain the highest level of utility that he can afford.
• Individuals act as if their actions do not affect prices (rates of exchange). There is no collusion
between individuals to fix total quantities or prices.
• Supply equals demand in all markets. In other words, markets clear!
Decentralized solutions: Without and With money scenarios
• Trade is not possible due to the ‘absence of double coincidence of wants’
• Equilibrium with money has fiat money in circulation.
• A “monetary equilibrium” is a competitive equilibrium in which there is a valued supply
of “fiat money”
• We began our analysis of monetary economies with an economy with a fixed stock of 𝑀
perfectly divisible units of fiat money.
• We assume that each initial old begins with an equal number, 𝑀/𝑁, of these units.
• The introduction of fiat money shows trade possibilities.
• A young person can sell some of his endowment of goods (to old persons) for fiat money, hold the
money until the next period, and then trade the fiat money for goods (with the young of that
period).
Decentralized solutions: Without and With money scenarios
• Budget constraints with fiat money
• It helps understand how individuals will decide how much money to acquire (assuming
that fiat money will have a positive value in the future).
• First Period:
• We denote number of Rupee acquired by an individual (by giving up some of the
consumption good) at time t is denoted by 𝑚𝑡 , then the total number of goods sold
for money is 𝑣𝑡 𝑚𝑡 .

• We can, therefore, write the budget constraint facing the individual in the first period
of life as:
𝑐1,𝑡 + 𝑣𝑡 𝑚𝑡 ≤ 𝑦 (7)
Decentralized solutions: Without and With money scenarios
• Budget constraints with fiat money
• It helps understand how individuals will decide how much money to acquire (assuming that
fiat money will have a positive value in the future).
• Second Period:
• In the second period of life, the individual receives no endowment. Hence, when old, an
individual can acquire goods for consumption only by spending the money acquired in
the previous period.
• In this period of life (period t + 1), this money will purchase 𝑣𝑡+1 𝑚𝑡 units of the
consumption good.
• We can, therefore, write the budget constraint facing the individual in the first period of
life as:
𝑐2,𝑡+1 ≤ 𝑣𝑡+1 𝑚𝑡 (8)
𝑚𝑡 ≥ (𝑐2,𝑡+1 /𝑣𝑡+1 ) (9)
After substituting (8) into (7), we get
𝑣𝑡 (𝑐2,𝑡+1 )
𝑐1,𝑡 + ≤y
𝑣𝑡+1
Decentralized solutions: Without and With money scenarios
• After substituting (8) into (7), we get
𝑣𝑡 (𝑐2,𝑡+1 )
𝑐1,𝑡 + ≤y
𝑣𝑡+1
Or
𝑣𝑡
𝑐1,𝑡 + (𝑐2,𝑡+1 ) ≤ y (10)
𝑣𝑡+1
• Equation (1) shows various combinations of first- and second-period consumption that an
individual can afford over a lifetime.
• In other words, it is the individual’s “lifetime budget constraint.”

𝑣𝑡
• considered as the “(real) rate of return of fiat money” because it expresses how
𝑣𝑡+1
many goods can be obtained in period 𝑡 + 1 if one unit of the gold is sold for money in
period 𝑡 .
Finding Fiat Money’s Rate of Return
• We also assume that individuals in our economy rationally form their future expectations.
The role of “rational expectations”.
• In this nonrandom economy, where there are no surprises, “rational expectations” means
that individuals’ expectations of future variables equal the actual values of these future
variables.
• We also assume that people have perfect foresight.
• Let us now employ the assumptions of stationarity and perfect foresight to find an
equilibrium time path of the value of money.
• In perfectly competitive markets, an object’s price (or value) is determined as the price at
which the supply of the object equals its demand.
Finding Fiat Money’s Rate of Return
• Demand for fiat money:
• The demand for fiat money of each individual is the number of goods each chooses to sell
for fiat money, which equals the goods of the endowment that the individual does not
consume when young 𝑦 − 𝑐1,𝑡 .
• The total money demand by all individuals in the economy at time 𝑡 is therefore
𝑁𝑡 (𝑦 − 𝑐1,𝑡 ).
• We know that the total supply of fiat money measured in Rupees is 𝑣𝑡 𝑚𝑡 , implying that
the total supply of fiat money measured in goods is the number of Rupees multiplied by
the value of each Rupee, or 𝑣𝑡 𝑚𝑡 .
Finding Fiat Money’s Rate of Return
• The total supply of fiat money measured in Rupees is 𝑣𝑡 𝑀𝑡 , implying that the total
supply of fiat money measured in goods is the number of Rupees multiplied by the value
of each Rupees, or 𝑣𝑡 𝑀𝑡
• The equality of supply and demand, therefore, requires that
𝑣𝑡 𝑀𝑡 = 𝑁𝑡 (𝑦 − 𝑐1,𝑡 ) (11)
Solving for 𝑣𝑡 becomes

𝑁𝑡 (𝑦−𝑐1,𝑡 )
𝑣𝑡 = (12)
𝑀𝑡
Equation (12) states that the value of a unit of fiat money is given by the ratio of the real
demand for fiat money to the total number of Rupees.
𝑁𝑡+1 (𝑦−𝑐1,𝑡+1 )
Similarly, for 𝑣𝑡+1 = (13)
𝑀𝑡+1
Finding Fiat Money’s Rate of Return
• Using equations (12) and (13) together, we have
𝑁𝑡+1 (𝑦−𝑐1,𝑡+1 )
𝑣𝑡+1 𝑀𝑡+1
= 𝑁𝑡 (𝑦−𝑐1,𝑡 ) (14)
𝑣𝑡
𝑀𝑡
To simplify this, we look for a stationary solution, where 𝑐1,𝑡 = 𝑐1 and 𝑐2,𝑡 = 𝑐2 for every
period 𝑡.
Equation (14) becomes
𝑁𝑡+1 (𝑦 − 𝑐1,𝑡+1 ) 𝑁𝑡+1
𝑣𝑡+1 𝑀𝑡+1 𝑀𝑡+1
= =
𝑣𝑡 𝑁𝑡 (𝑦 − 𝑐1,𝑡 ) 𝑁𝑡
𝑀𝑡 𝑀𝑡
Finding Fiat Money’s Rate of Return

• Because we are assuming a constant population (𝑁𝑡+1 = 𝑁𝑡 ) and a constant supply of

money (𝑀𝑡+1 = 𝑀𝑡 ), the terms in Equation (15) cancel out and we find that
𝑣𝑡+1
𝑣𝑡
= 1 or 𝑣𝑡+1 = 𝑣𝑡 (16)

• Equation (16) shows a constant value of money.

• Because the price of the consumption good 𝑃𝑡 is the inverse of the value of money, it
too is constant over time.
Finding Fiat Money’s Rate of Return

• Notice that the rate of return on fiat money is also a constant (1) in the stationary
equilibrium.
• Identical people who face the same rate of return will choose the same consumption and
money balances over time, a stationary equilibrium.
• Using equation (16), we can find the stationary monetary equilibrium from Equation (10)
𝑣𝑡
𝑐1 + (𝑐2 ) ≤ y
𝑣𝑡+1
• We determine that 𝑐1 + 𝑐2 = 𝑦
 The Quantity Theory of Money
• The simplest version of the “quantity theory of money” predicts that the price level is exactly
proportional to the quantity of money in the economy.
• Does OLG capture this theory?
• Recalling equation (12), we showed the value of money as:
𝑁𝑡 (𝑦−𝑐1,𝑡 )
𝑣𝑡 =
𝑀𝑡
• In a stationary equilibrium with a fixed population and a fixed stock of fiat money, this
equation simplifies to:
𝑁(𝑦−𝑐1 )
𝑣𝑡 = (17)
𝑀
The Quantity Theory of Money
• In a stationary equilibrium with a fixed population and a fixed stock of fiat
money, this equation simplifies to:
𝑁(𝑦−𝑐1 )
𝑣𝑡 = (17)
𝑀
• Because the price level is the inverse of the value of money (𝑃𝑡 = 1/𝑣𝑡 ), we
can write an expression for the price level as:
1 𝑀
𝑃𝑡 = = (18)
𝑣𝑡 𝑁(𝑦−𝑐1 )

• Equation (18) shows that the price level in every period will also be twice as
high as increase in M. This demonstrates that our model is indeed consistent
with the quantity theory of money.