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 9
ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 1 / 41

1. 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 .

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.

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
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 .

2. Capital

Introducing Capital
In our benchmark model individuals used money to provide for their

consumption in their second period of life (c2 ).
In the real world many other assets can serve this role.
Focus here on capital as an alternative to holding money, because

capital produces goods and affects the economy’s future output.
Main conclusions applicable to other assets.
Additional question: how does the presence of an alternative asset

affect people’s willingness to hold fiat money?

Simple Model with Capital
Start with the simplest OLG model with capital, denoted kt per
young person.
Production Technology: if kt units of the consumption good are

converted into capital goods at time t → at t + 1 you will receive xkt
consumption goods.
I x is a positive constant → the gross real rate of return to capital.
Assume 100% depreciation rate: capital goods produce only once

before disintegrating.
Individuals are endowed with y units of the consumption good when

young, and 0 when old.
Population grows at a constant gross rate n > 1.

Simple Model with Capital
Each initial old begins with a stock of capital k0 , that produces xk0
goods in the first period.
First analyze the equilibrium without fiat money.
The capital technology enables the young to use some of today’s

consumption good to produce the consumption good in the next
period.
Individual allocation problem: when young, the individual decides how

much of their endowment to consume and how much to convert to
capital.

Budget Constraints
Budget constraint when young of an individual born in period t,
c1,t + kt ≤ y
Budget constraint when old of an individual born in period t,
c2,t+1 ≤ xkt
→ individual consumes the goods produced by their capital holdings.
Lifetime budget constraint of individual born in t,

c2,t+1
c1,t + ≤y
x
→ x determines the slope of the budget constraint.

Since I
X y 7 Y
Ci
L y c
savings in the
Form of capital
Diminishing Returns Production
In this simple model it was assumed that output from each unit of
capital is the same regardless of how much capital already exists
→ the rate of return to capital is a fixed number x, unaffected by
economic forces.
Consider the alternative assumption that capital exhibits a

diminishing marginal product (MPK ):
I As capital is increased the additional output from an extra unit of
capital gets smaller (total capital still increases as long as MPK > 0)
In this case we write output per person as a function of capital per

person: f (kt ) → total product generated in period t + 1 from
purchasing kt units of capital in period t.

Diminishing Returns Production
Then the additional output from an additional unit of capital is,
∆f (k)
MPK = = f 0 (k) > 0
∆k
→ upward sloping production function.
and a diminishing MPK implies,

∆MPK
f 00 (k) = <0
∆k
→ concave production function.
When markets are competitive then MPK = f 0 (k) is also the real rate
of return to capital.

Diminishing Returns
Ek
LY
Total Prodeet
Constant Returns
fcq x
o h
Total Product
f Kk x
x risk
h
Marginal Product
3. Rate of Return Equality

Alternative Assets
Capital is not the only alternative to fiat money.
People can store value over time (save) in many other ways.
I e.g., purchase land and sell it when they want to consume; make loans
to people who want to borrow against future income (private debt).
What are the implications of the presence of alternative assets?
Consider an economy with both capital and private debt (loans):

I capital → rate of return = x
I private debt → real interest rate = r

Returns Across Alternative Assets
Suppose that r < x.
Would individuals be willing to make loans to people who wish to
borrow?
No! because they would be accepting a lower rate of return than can
be achieved by creating capital → people would prefer to put all their
savings into the creation of capital.
Borrowers who wanted to borrow must entice people to make them
loans by offering at least as good a rate of return as x.
Suppose that r > x.
Would individuals be willing to save in the form of capital?
No! because they would be accepting a lower rate of return than can
be achieved by making loans → people would prefer to put all their
savings into private loans.
Rate of Return Equality
For people to be willing to hold both capital and loans as assets, their
rates of return must be identical,
r =x
→ any imbalance and people would tend to gravitate to the asset

paying the higher return.
Implicit assumption: capital and private debt are perfect substitutes

from the viewpoint of people willing to save: either asset can provide
just as well for c2 → to observe both assets being held their rates of
return must be identical.

Rate of Return Equality
More generally, when there are many assets available to the individual, and
there is no uncertainty about returns and no government restrictions
interfering with the individuals’ holdings of those assets, it must be that
their returns are identical if individuals are to hold them all simultaneously.
→ PRINCIPLE OF RATE OF RETURN EQUALITY

Can fiat money co-exist with another asset?
Suppose we introduce fiat money into our economy, along with

capital and private loans → 3 potential ways for lenders to save.
People who want to save view capital, loans and money as perfect
substitutes.
Then, for lenders to be willing to hold all three assets as a form of

saving their rates of return must be equal.
vt+1
Recall, real rate of return to fiat money (general case) → vt = nz .
Then real rate of return equality means:

n
=r =x
z

Can fiat money co-exist with another asset?
If nz < r = x then individuals will choose to not hold money as a form

of saving.
So for fiat money to be valued its rate of return must be at least as

large as those on alternative assets (capital and loans here).
Example: suppose that there is only capital and fiat money, and that
n = 1.5 and x = 1.25. When will fiat money be valued?
n 1.5 1.5
I Answer: if z ≥x ⇒ z ≥ 1.25 ⇒ z ≤ 1.25 = 1.2.

4. The Tobin Effect

Tobin Effect
There are two assets: capital (k) and fiat money (m).
Assume that capital exhibits a diminishing MPK , i.e., f 00 (k) < 0.
If capital and fiat money co-exist as perfect substitutes we must

observe rate of return equality between the two assets.
When fiat money and capital are both valued the desired capital stock
k is determined by real rate of return equality condition.
Real rates of return:

I capital → MPK = f 0 (k) (extra output from an extra unit of capital).
I fiat money → vvt+1
t
= nz .

Tobin Effect
Real rate of return equality principle implies,

vt+1 n
MPK = ⇒ f 0 (k) =
vt z
This condition determined an individual’s desired capital stock k ∗
(one equation in one unknown).
In the figure, when the real rate of return to fiat money is n/z the
desired capital holdings k ∗ are where the MPK curve (downward
sloping in k) intersects the n/z line.

i
Tobin Effect
Consider now a permanent increase in the anticipated rate of return

to fiat money creation from z to z 0 > z.
The increase in z generates inflation → lowers the anticipated rate of

return to fiat money from nz to zn0 → the lower rate of return on fiat
money induces people to hold more capital instead → ↑ k → ↓ MPK .
People stop switching from fiat money to capital either when fiat
money balances have fallen to zero (m → 0) or when the rate of
return on capital falls to the new lower rate of return to fiat money,
0 n n
f 0 k∗ = 0 <
z z
0
→ k ∗ > k ∗.

Tobin Effect
In the figure, after the increase in z, at the initial desired capital

holdings k ∗ , we have that,
n
f 0 (k ∗ ) >
z0
→ k will increase.
Tobin Effect (due to Tobin, 1965): the substitution towards private

capital and away from fiat money in reaction to an increase in
anticipated inflation → when capital and fiat money are substitutes
an increase in z leads to an increase in k.
Given that capital generates output next period, the larger the capital
stock, the larger the subsequent increase in output.

Tobin Effect
Total real output (real GDP) in period t:
GDPt = Nt y + Nt−1 f (kt−1 )
I Nt y = total endowment of young in t

I Nt−1 f (kt−1 ) = output generated by capital created in t − 1 by the
young in t − 1 (old in t).
Policy Question: if we live in a world in which capital and fiat money

are substitutes should we use anticipated inflation as a tool to
increase output?
The answer may be “no” for two reasons:
I output is not the same as welfare → economy may over-accumulate
capital.
I in the real world this effect not that large, as the size of the money
stock very low relative to the capital stock.

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 9 2021 1 / 41

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 2 / 41

Take a more long-term view now.

Up to now we used the OLG model as a model of money: people

We did not interpret c2 literally as consumption in old age because

We focus on capital and government bonds because they constitute

How do individuals choose their savings?

Standard two-period OLG model in which individuals choose how

Each individual has endowment of y1 of the good when young

The young face a gross real interest rate of r .

They choose how much to save st .

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 4 / 41

Budget constraint when young in period t,

Budget constraint when old in period t + 1,

Combine the two to get the lifetime budget constraint,

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 5 / 41

Note the endowment point CY Yz

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

This occurs where the highest possible indifference curve U 0 is

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

If savings are zero, then individual consumption in each period is

Saving allows an individual to choose a bundle (c1 , c2 ) constrained

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 7 / 41

t one period ttt

with a one period loan

if loan over T periods duration

if payments in each period

Sitt PV of second period cons

Yf PV of second period income

Then we can re-write the intercepts of the lifetime budget constraint

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

If the consumption of a good decreases when the wealth increases,

However, (c1 , c2 ) are unlikely to be inferior goods, because they are

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 8 / 41

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

Distinguish between income and wealth,

The above analysis suggests that it is wealth, not income, that

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

Focus on lump-sum taxes in terms of goods (real terms): τ1 on each

Budget constraint when young,

Budget constraint when old in period t + 1,

Combine the two to get the lifetime budget constraint,

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 10 / 41

Initial taxes on the young and old: (τ1∗ , τ2∗ ).

Does this tax policy change affect the taxpayer’s wealth?

Substitute the new taxes in,

Reason: in PV terms the ↓ τ2 exactly offsets the ↑ τ1 .

Since w is not affected the (c1∗ , c2∗ ) combination desired by the

How is this (c1∗ , c2∗ ) implemented? You reduce your st by 10 goods to

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 12 / 41

Tax policy change:

What is the effect on consumption-saving?

What happens to savings?

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 13 / 41

ECON3440C - Adamopoulos Monetary Economics, Lecture 9 2021 14 / 41

In our benchmark model individuals used money to provide for their

Focus here on capital as an alternative to holding money, because

Main conclusions applicable to other assets.

Additional question: how does the presence of an alternative asset