Monetary Economics II: Theory and Policy

ECON 3440C

Tasso Adamopoulos
York University

Fall 2021
Lecture 1

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 1. About the Course

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Approach of the course

Course on monetary theory.

“Traditional” approach vs. “Micro-foundations” approach.

The value in the micro-foundations approach

(approach in this course).

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A Traditional Approach

Money is assumed to be needed to undertake transactions.

Constructs macro models based on assumed behavioural relationships.

Demand function for real money balances,

MD
= L (r + π, Y )
P
Money supply M is exogenously determined by Central Bank.

Equilibrium in the money market,

M
= L (r + π, Y )
P

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A Traditional Approach

Consumption function,

C = C0 + MPC · Y D

Y D = (1 − τ ) Y
Investment function,
I = I0 − Ir · r
Government expenditures,
G = G0
Goods market equilibrium,

Y =C +I +G

Examines how markets interact to trace the effects of monetary policy.

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Potential Issues

Assumed relationships may not be derived from optimization.

Changes in policy alter the economic environment, and potentially the

relationships among aggregate variables.

May not be used to draw the welfare implications of policy changes.

Do not provide a rationale for the existence of money.

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Simple Example
Data on C Y over 1970 2020
with I O Z

C Co t MPC Y
D

Y's Cc z Y

Estimate with historical data to

get Io MIC
capture behaviour of agents with
policy regime of Z O Z

IF 2
changes to 2 0.3 then
agent behaviour and thus
Co NPC may change
Micro-foundations Approach

Constructs monetary macro models from micro principles.

Aggregate macroeconomic variables are the equilibrium result of

choices of rational individuals who seek to maximize their welfare
subject to some constraints.

Allows for individual agents to alter their decisions in response to

policy changes.

Allows to derive a role for money rather than just assume it.

In the course we will use micro tools (indifference curves and budget
lines) to address monetary issues.

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 2. Introduction to Money

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What are the functions of money?

Medium of exchange: use it to undertake transactions.

Store of value: use it to transfer wealth across time.

Unit of account: use it to quote prices and set up contracts.

A definition: Money is an object that circulates widely as a means of

payment.

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Puzzle

Why would people hold pieces of paper money that are intrinsically
worthless? Why do people value fiat money?

Demand for money is different from the demand for goods, because
goods provide direct utility.

Money can generate utility indirectly by operating as a medium of

exchange, i.e., it facilitates exchange between people.

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Necessary Conditions for Fiat Money to be Valued

1 Trading Friction: There must be some trading friction that precludes

people from directly acquiring the goods they want to consume, e.g.,
lack of double coincidence of wants.

2 Future Periods: Someone is willing to hold money from one period

to the next. People will accept it today only if they believe that they
can trade if for something valuable tomorrow.

A necessary condition for money to be valued when agents are rational is

that the economy goes on forever with some positive probability ⇒
need a dynamic model for money.

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Tt
Two Workhorse Dynamic Macro Models

1 Infinite horizon Walrasian (competitive) model with infinitely lived

agents.

2 Overlapping generations model (OLG): economy goes on forever,

agents are finitely lived but generations are overlapping.

Notes:
In a frictionless Walrasian world there is no role for money.

The OLG model has the friction of incomplete markets: markets

between currently alive agents and future generations do not exist.

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 Walroesia Model

I Z 3
oo

T
agents same agent
born live forever

01 G Model

00
o l 2 3
1 1
1 1 economy goes
agents live
on
Forever
For 2 periods
Desirable Features of OLG Model

Tractable and easy to use.

Dynamic.

Parsimonious framework to introduce the existence of money because

money endogenously overcomes a friction.

We will develop the basic OLG model with money.

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Monetary Issues and Policy

What causes inflation?

What is the cost of inflation?

Quantity theory of money.

Effect of monetary policy on real variables and output.

Effect of monetary policy on national debt.

Commitment issues in the conduct of monetary policy.

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 3. Overlapping Generations Model:
Environment

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Environment

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.

Economy begins in period t = 1 and goes on forever.

Closed economy: no interactions with the rest of the world.

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Environment

In each period Nt individuals are born, e.g.,

N2 = number of individuals born in period 2.

Individuals born in periods 1, 2, 3, ... are called future generations.

In period t = 1 there are N0 initial old.

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)

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Environment

Single good in economy at every date t.

There is no storage technology.

There is no production in this economy, i.e., it is an endowment

economy. Each individual receives an endowment of the single
consumption good, (
y , when young.
0, when old.

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Overlapping structure of Cohorts

N3 Young Nz old
Nz Young
N young N old

t I t z t 3 t 4
 Pattern of Endowments
period

enerati
itial O O
old
1 O
y

4
g 3
s
og
o

o
y
44
51 y o
 4. Overlapping Generations Model:
Preferences

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Preferences of Future Generations

Individuals derive utility from consuming the economy’s single

commodity.

Individuals like to consume in both periods of life,

I c1,t = consumption of individual born in t when young
(first period of life)
I c2,t+1 = consumption of individual born in t when old
(second period of life)

Note: not c2,t . This is the consumption of an individual born in t − 1

in their second period of life.

Individuals care about bundles (c1,t , c2,t+1 ) over their lifetime.

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Preferences of Future Generations

Individual preferences are captured by a utility function

U (c1,t , c2,t+1 ), which ranks lifetime consumption bundles.

A bundle is preferred to another if it gives the individual more

satisfaction than the other.

The individual is indifferent between two consumption bundles if they

provide the same utility.

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Assumptions about Preferences

More is preferred to less: for a given amount of consumption in one

period, individual utility increases with more consumption in the other
period.

Individuals like diversity in their consumption bundles: individuals do

not like extremes (like to smooth consumption).

Diminishing marginal rate of substitution (MRS): to receive an extra

unit of c2 , and be equally happy, the individual is willing to give up
more c1 when c1 is abundant than when it is scarce.

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Preferences and Representation
Given these preferences an individual can rank consumption bundles,
e.g.,  
A : c1A , c2A
 
B : c1B , c2B

Portray individual preferences graphically using indifference curves.

Indifference curve: connects a set of points, each of which represents

a consumption bundle, among which the individual is indifferent.

Two consumption bundles A, B on the same indifference curve give

the individual the same utility,
   
U c1A , c2A = U c1B , c2B

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 Cane
A typical indifference

Cz r

aµ
B I i
E l o

I i
B C
GA C
Properties of Indifference Curves

1 Indifference curves get flatter as we move from left to right

(convexity). Due to the property of diminishing MRS.

2 Indifference curves become infinitely steep as we approach the vertical

axis, and perfectly flat as we approach the horizontal axis, never
crossing the axes.

3 Indifference curves are dense in the (c1 , c2 ) space.

4 Indifference curves moving north-east represent higher levels of utility.

5 Indifference curves do not cross (transitivity).

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Higher utility on
higher indifference comes

CZ n

B
B f
Cz i
i
i
o

ga
i 2
I l
U

D
1
Ct C

U C ga GA s UC GA CE
since CzB czA

U C GA GA E U CC Cz't
since CP c t
Indifference Curves cannot cross

Czt

It

9
Preferences of Initial Old

They live for only one period, t = 1.

They want to maximize their consumption in that period.

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 5. Overlapping Generations Model:
Problem and Solutions

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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.

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