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 6
ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 1 / 41

1. Recap: Seignorage

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?

Government Budget Constraint
The newly printed money now is used to finance the government’s

acquisition of goods, i.e., government purchases Gt (not subsidies).
Government budget constraint when revenue from printing money is

used for buying goods by the government,

1
Gt = 1 − Mt vt
z

Stationary Monetary Equilibrium
The real rate of return to fiat money with seignorage is,

vt+1 1
=
vt z
pt+1
which induces inflation pt = z.
Budget constraint of individual in the SME,
c1 + zc2 ≤ y

Feasibility Constraint
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,
c1 + c2 + g ≤ y

Efficiencyofs.ME
2. The Limits to Seignorage

Seignorage revenue
Does seignorage represent an unlimited source of government

revenue? Can the government simply print enough money to pay all
its bills without direct taxation?
There are limits to seignorage.
Although, the government can print any amount of dollars, the value
of the dollars shrinks as the government prints more fiat money.
Thus, government revenue in terms of real goods is limited by the

real value of the fiat money stock.

Seignorage revenue
The government’s real revenue from seignorage (Mt − Mt−1 ) vt , can

be written as:

1
(Mt − Mt−1 ) vt = 1 − vt Mt
z
vt Mt = real value of fiat money.
1 − z1 = fraction of value of real fiat money that winds up as

government revenue.

Seignorage tax base - tax rate
Tax base: what is being taxed?

I here, the real value of stock of fiat money, vt Mt → seignorage tax base.
Tax rate: at what rate is the base being taxed?

I here, the fraction ofthe value of fiat money that goes to the
government, 1 − z1 → seignorage tax rate.

First limit to seignorage
Suppose, for a moment, that the real fiat money stock vt Mt remains
constant at vt Mt , as z increases.
Implicit assumption: people will want the same level of real money
balances even after the rate of inflation rises.
If this was the case, then real seignorage revenue would always be
increasing in z.
The revenue however would be bounded: as z → ∞ ⇒ the seignorage

1

tax rate 1 − z → 1 ⇒ the entire real value of money balances vt Mt
is acquired by the government.
Note: this quantity is finite → limited by the real demand for money
vt Mt = Nt (y − c1,t ).

First limit of seigniorage
the amount that you co r
tax
is Finite
Seigniorage
Revenue
Tent
I
I
1 u
seigniorage
tax rate
you cannot fax more
than 1004 of the tax base
Second limit to seignorage
There is a more severe limit on the real value of seignorage revenue.
As the rate of inflation increases, each individual will choose to reduce

their holdings of money balances (y − c1∗ ) in the SME.
The total demand for money Nt (y − c1∗ ) falls, as ↑ z.
Through, the market clearing condition this reduces the real value of
fiat money the government can tax, i.e., the seignorage tax base,
vt Mt = Nt (y − c1∗ ), as the seignorage tax rate increases with ↑ z.
Note: the real value of money vt falls.

Second Limit of Seigniorage
The tax base will shrink
Seignorocke
e
Revenue
ai
µ I l
t l l
l l
l i
El E Z Z
Seignorage Laffer Cuore

Message
If the government inflates the stock of fiat money too rapidly, it may
raise less revenue in real terms than it could raise with a lower rate of
money creation.
The relationship between seignorage tax rates - tax revenues is similar

to the Laffer curve, that hypothesizes a similar relationship between
income tax rates - tax revenues,
Tax Revenue = Tax Rate · Tax Base = t · Income
The government might increase tax revenue by cutting income taxes.
Similarly, the government can increase seignorage revenue by

decreasing the rate of money creation.

Income tax revenue tax rate
Laffer Curve
tax referee
f
f
I I
ti ta t
tax
rate
Revenue t x income
3. Real Effects of Monetary Policy

Does money affect the real economy?
Money is neutral if the level of the stock of fiat money does not
affect real choices.
Money is superneutral if the growth of the stock of fiat money does

not affect real choices.
In the OLG model we looked at, is money neutral and/or

superneutral?

Money is neutral in our OLG model.
The level of the stock of fiat money M does not alter the individual
optimal choice (c1∗ , c2∗ ), i.e., it is the same as the Golden Rule and the
quantity theory of money holds.
Recall: a one-time permanent change in M would lead to a

proportionate one-time nominal change in prices p, but would not
alter the real allocation.

Money is not superneutral in our OLG model.
With money expanding at rate z, Mt = zMt−1 : ↑ z induces

individuals to make inefficient choices because of the inflation tax.
Recall: ↑ z leads not only to a proportionate increase in inflation, but

also alters the real allocation.

Does this model say anything about output?
No, because output is exogenous: individuals have endowments and

make no decision about how much to produce and thus how much to
work.
Important policy question: can the government affect output, by

expanding the supply of fiat money?
I we cannot address this question in the model we had up to now.

Does money affect real output?
Why is this question important and what do the data say?
Evidence in favourof the quantity theory of money: if you plot

inflation ppt+1
t
− 1 against the growth of the money supply (z − 1)
the correlation in the data is almost 1, especially over low frequencies
(5-10 year periods).
pt+1
This is consistent with our OLG model where, pt = z.
Phillips curve: in 1958, Phillips discovered a significant statistical

inverse relationship between the inflation rate and the unemployment
rate for the UK over a century.
I similar pattern for the US over 1948-1969.

Relationship between Inflation
money growth
In 1
Pt
Phillips Cane
inflation
inverse
relationship
or
inflation
positive
Liii
Graph for US after 1970
inflation
P
unempt
rate
or
output
growth
Phillips Curve implications
Implication: there is a trade-off between inflation and unemployment
that a government can potentially exploit → by increasing inflation
the government might achieve lower unemployment and higher
output.
In the 1950s and 1960s many governments tried to use monetary

policy to stimulate the economy → suddenly the Phillips curve, a
stable relationship over a century disappeared.
Inflation occurred with no gains for output and employment →

stagflation.
In the long-run money growth appears superneutral, although in the

short-run it is not superneutral (positive relationship between inflation
and output).
Cross-country comparisons in Lucas (1973): countries with lower

average real growth rates, also had on average higher inflation rates.
Lucas (1972)
In “Expectations and the Neutrality of Money” (Lucas, 1972), Lucas

addressed the above puzzle proposing a model economy consistent with:
a positive short-run correlation between inflation and output
the disappearance of that correlation when policy makers attempt to

exploit it
a negative correlation between long-run inflation and output across

countries.

4. The Lucas Model

Environment
Standard OLG model of money.
Assumption: individuals live in two spatially separated islands

(distinct markets).
Total population N across the two islands is constant over time.
Half (1/2) of the old individuals in any period live on each of the two
islands.
The old are randomly distributed across the two islands,

independently of where they lived when young → implies you do not
know where you will be next period.

Environment
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
In any single period, each island has an equal chance (1/2) of having
the large population of young.
The outcome of this random assignment of the population has no
effect on the outcome in any other period.
The stock of fiat money grows according to,
Mt = zt Mt−1
Note: zt is time-varying (random variable)
Increases in the stock of fiat money are given to the old as lump-sum
subsidies per person,

1 vt Mt
at = 1 −
zt N
N old N old
I
3N young f N
young
Environment - informational assumptions
In any given period,the young can directly observe neither the number
of young people on their island N i , nor the size of the subsidies to the
old at (i.e, zt ).
The nominal stock of fiat money balances is known with a delay of

one period, i.e., in t you know Mt−1 but not Mt .
The price of goods on an island pti is observed but only by the people
on that island.
No communication between islands is possible within a period (you

need this otherwise they could infer zt from central market clearing).

Environment - expectations
Rational expectations.
Individuals know the possible outcomes they face and the probabilities
of each outcome.
Individuals make the best possible inference given the information

they have (i.e., price pti ).

Re-interpretation of individual problem in OLG
When young, individuals are endowed with y units of time.

I y = time endowment of the young
The young can allocate their time between leisure - denoted c1 , and
work/labour - denoted `.
When they young work they produce goods, which they sell to the old
in exchange for money.
They then carry that money over to the next period and use it to
purchase the market good c2 in that period.

Individual problem in OLG
The young work (give up leisure) to produce goods to sell to the old.
Let ìt = ` pti represent the choice of labour by an individual born in

period t, for a given price of goods pti on island i.
Technology for producing goods:

each unit of labour produces 1 unit
of goods → implying that ` pti also represents the individual
production of goods.
Note: the amount of labour supplied by an individual depends on the

price the individual receives on the goods produced.

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

5. Non-random inflation
in the Lucas Model

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

inflation).
Individuals can determine the current money stock Mt by multiplying

Mt−1 (which they know by assumption) by the anticipated z:
Mt = zMt−1 .
vti mti = ìt = ` pti = each young person’s demand for fiat money in

period t.
N i ` pti = total demand for fiat money on island i (since N i young)


Market Clearing on island i
Given that the old are equally distributed between the two islands
(regardless of birth place), and this is done every period, half of the
stock of fiat money ends up on each of the two islands, Mt /2.
vti M2t = total real supply of fiat money in period t on island i.
Market clearing condition for fiat money in terms of goods,

Mt
N i ` pti = vti

2

Implied prices
Since vti = 1/pti we can re-write the market clearing condition,
Mt /2
N i ` pti =
pti
We can then solve implicitly for the price level on island i,
Mt /2
pti =
N i ` pti

Note, that depending on whether island i has a small or large number

of young the possible values for N i are: 31 N and 23 N.
Because the population of the young on each island is the only

random variable, the market clearing condition implicitly expresses the
price level as a function of the population of young N i .
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.

Outcomes on each island
Of course, because there is always one island with 32 N young and

another with 13 N young people, aggregate output does not depend on
which of the two islands has the larger number of young.
Prices here do the job we expect them to do in market economies:

they signal the true state of the world to people, so that they can
choose the quantity of their work/output that maximizes their well
being, given their true situation.

Effect of money increases on output - level
Will the young react to high prices in the same way, i.e., by ↑ ìt if
they know the high prices are caused by a once-and-for-all higher
level of fiat money stock? No!
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.
A high current price caused by a permanent increase in the money

stock does not affect the rate of return to labour and thus the desire
to work → money is neutral in this case.
Effect of money increases on output - growth rate
What is the effect of anticipated inflation z on work? Is money

super-neutral? No!
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.
Note: this happens on both islands at the same time.
This implies that if I compare two different economies with different

fixed z’s the economy with the higher z will have lower aggregate
employment and output.

This implies a negative correlation between inflation and aggregate

output (employment) across economies with different but constant
rates of fiat money expansion z.
Note: this result appears in contrast to the Phillips curve, which

predicted a positive relationship between inflation and output (or
negative relationship between inflation and unemployment).
However, the figure represents a cross-section, i.e., a comparison of

two distinct economies, each with a different fixed inflation rate.
The figure is consistent with the evidence in Lucas (1973), who finds
a negative correlation between inflation and output across countries.

The Phillips curve is a time-series comparison of inflation and

unemployment across different periods of the same economy.
To see whether our model is consistent with the Phillips curve we

must introduce variation in the inflation rate over time.

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Monetary Economics II: Theory and Policy

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 1 / 41

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 2 / 41

The government can print new money costlessly.

A government that needs to raise revenue for government purchases

Seignorage: the use of money creation as a revenue device.

What are the welfare effects of this policy?

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 3 / 41

The newly printed money now is used to finance the government’s

Government budget constraint when revenue from printing money is

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 4 / 41

The real rate of return to fiat money with seignorage is,

Budget constraint of individual in the SME,

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 5 / 41

The feasible set with government purchases,

Nt c1,t + Nt−1 c2,t + Gt ≤ Nt y

Under a stationary allocation,

With a constant population, the stationary per capita feasibility

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 6 / 41

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 7 / 41

Does seignorage represent an unlimited source of government

There are limits to seignorage.

Thus, government revenue in terms of real goods is limited by the

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 8 / 41

The government’s real revenue from seignorage (Mt − Mt−1 ) vt , can

vt Mt = real value of fiat money.

1 − z1 = fraction of value of real fiat money that winds up as

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 9 / 41

Tax base: what is being taxed?

Tax rate: at what rate is the base being taxed?

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 10 / 41

The revenue however would be bounded: as z → ∞ ⇒ the seignorage

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 11 / 41

There is a more severe limit on the real value of seignorage revenue.

As the rate of inflation increases, each individual will choose to reduce

The total demand for money Nt (y − c1∗ ) falls, as ↑ z.

Note: the real value of money vt falls.

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 12 / 41

The tax base will shrink

Seignorage Laffer Cuore

The relationship between seignorage tax rates - tax revenues is similar

Tax Revenue = Tax Rate · Tax Base = t · Income

The government might increase tax revenue by cutting income taxes.

Similarly, the government can increase seignorage revenue by

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 13 / 41

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 14 / 41

Money is superneutral if the growth of the stock of fiat money does

In the OLG model we looked at, is money neutral and/or

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 15 / 41

Money is neutral in our OLG model.

Recall: a one-time permanent change in M would lead to a

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 16 / 41

Money is not superneutral in our OLG model.

With money expanding at rate z, Mt = zMt−1 : ↑ z induces

Recall: ↑ z leads not only to a proportionate increase in inflation, but

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 17 / 41

Does this model say anything about output?

No, because output is exogenous: individuals have endowments and

Important policy question: can the government affect output, by

ECON3440C - Adamopoulos Monetary Economics, Lecture 6 2021 18 / 41

Why is this question important and what do the data say?

Evidence in favourof the quantity theory of money: if you plot

Evidence in favourof the quantity theory of money: if you plot