CHAPTER 8

Money and Inflation

1. Introduction
It may appear curious to most of you that in discussing theories of the macro-
economy, we have to this point avoided mentioning money. In Chapter 2, for
example, we thought of the labor market as a place where households exchange
their labor for goods. In reality, households exchange their labor for money
first, and then exchange their money for goods. But does this intermediate step
really matter? It is evident that people do not value money for its own sake
(you cannot eat money, for example). When people exchange labor for money,
they do so because they expect to use their money as a claim against output. To
the extent this is true, we see that money is just a “veil” that conceals the true
fundamentals that underlie the motivation for exchange. The earlier chapters
in this text simply removed this veil.
On the other hand, the fact that money is used in exchange does imply that
money must serve some role in the economy. We all have an intuitive sense
that money facilitates the exchange process. That is, monetary exchange helps
people engage in trades that they might not otherwise engage in without money
to serve as a means of payment. In this chapter, I develop a simple model
intended to capture this basic idea. I then use the model to help us understand
the determination of a variety of nominal economic variables, for example, the
price-level, inflation, the nominal interest rate, and the nominal exchange rate.

2. A Simple Monetary Model

Consider an economy where time is indexed by t = 1, 2, ..., ∞. At the initial
date 1, there are N agents who live for one period only. Call these agents
the “initial old.” These agents are endowed with nothing but money. If we
let M denote the initial money supply, then each initial old agent is endowed
with (M/N ) dollars. The initial old value consumption; which I denote c0 . If
possible, they would like to trade their money for output.
But with whom might the initial old trade their money? Imagine that at date
1, there also exist N agents who are endowed with no money, but are instead
endowed with one unit of time and an ability to produce (nonstorable) output
with a technology y = z(1 − l). Here, z > 0 denotes an exogenous productivity
parameter, and l denotes leisure (time devoted to home production). Assume
that these agents live for two periods; so that at date 1 they are “young” and
at date 2 they are “old.” Assume further that these agents do not value output

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when young; but that they do value leisure when young. These agents also
value output when they become old. We can summarize their preferences with
a utility function u(l, c); where l denotes leisure when young and where c denotes
consumption when old.
Let’s summarize what we have so far. At date 1, we have N initial old
agents who desire output, but have nothing to offer in exchange except possibly
money. At date 1, we also have N initial young agents who might potentially
produce output (at the cost of foregone leisure). The question here is whether
they young might be willing to work for money.
The answer to this last question is not so obvious. After all, work requires
effort (foregone leisure). And the young cannot eat money (paper tastes lousy).
But seeing as how the young value output in the future when they are old
(much like the current old value output today), they young might be willing
to work for money if they expect money to have value in the future. To allow
for such a possibility, let us assume that at each date t ≥ 2 there is a new
generation of young agents of size N who enter the economy. Assume that these
new generations of young agents have identical preferences and are endowed
in exactly the same way. Since everyone lives for exactly two periods, the
population of this economy will forever be fixed at 2N (an equal number of
young and old at each date).
Now, let us imagine that money is used to purchase output at each date on
a competitive spot market. Let pt denote the price of output measured in units
of money at date t (this is the date t price-level). Let us take as given, for the
moment, a sequence of prices (a price-system) p ≡ {p1 , p2 , ..., p∞ }. For money
to have value, it must be the case that pt < ∞ at every date t; so let us assume
(for the moment) that this is the case (we will verify later that this will be the
case).
Next, consider the choice problem facing a representative young agent at
some date t. This agent has the option of producing output y = z(1 − l). Since
the young agent does not value this output, his best option is to sell it for money
mt . If the price of output is pt , then:
mt = pt z(1 − l). (44)
The money accumulated in this manner can then be carried over into the next
period, where it can be used to purchase output. This implies:
pt+1 c = m. (45)
Combining equations (44) and (45), we have:
pt
c= z(1 − l). (46)
pt+1
Equation (46) describes how a young agent can trade off current leisure for
future consumption, given a price-system p. That is, equation (46) is the agent’s
intertemporal budget constraint.

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 Let Πt+1 ≡ pt+1 /pt . That is, Πt+1 represents the expected (gross) rate
of inflation (the rate of change in the price-level). In what follows, I am
going to restrict attention to stationary equilibria. That is, let us assume that
Πt+1 = Π. In this case, we can state the representative young agent’s choice
problem formally by the statement:

Choose (l, c) to maximize u(l, c) subject to: c = Π−1 z(1 − l). (47)

The solution (lD , cD ) can be depicted in the usual way by using a familiar
diagram; see Figure 8.1.

FIGURE 8.1
The Demand for Real Money Balances

c c = Π z - Π zl
-1 -1
Budget Line

A
cD

slope = - Π-1z

0 lD 1.0 l

nS

Figure 8.1 is labeled “the demand for real money balances.” This label is
motivated by equation (44), mt = pt z(1 − l). That is, a young agent who works
(1−l) hours produces z(1−l) units of output, which he exchanges for mt dollars.
Hence, mD D
t ≡ pt z(1 − l ) denotes the demand for nominal money balances.
The purchasing power of mt dollars is given by mt /pt . Therefore, the demand
for real money balances is given by:
µ D¶
mt
= z(1 − lD ).
pt

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For notational convenience, let me define qt ≡ mt /pt . In this case, we can write
the demand for real money balances as:
q D = z(1 − lD ). (48)
Note that the demand for real money balances depends on the productivity
parameter z. It will also depend on z and Π via the effect that these variables
have on labor supply nS = (1 − lD ).

2.1 Properties of the Money Demand Function

According to this theory, the demand for real money balances should depend
on both z and Π; a fact that we can stress by writing q D (z, Π). Keep in mind
that Π should be interpreted here as the expected inflation rate.
From Figure 8.1, it is clear that an increase in Π will serve to make the
budget constraint “flatter.” That is, future consumption (which can only be
acquired with accumulating cash today) becomes more expensive relative to
leisure. Alternatively, you can think of Π−1 z as the expected return to labor.
As with any relative price change, there will be substitution and wealth effects
to consider. By equation (48), it is clear that the reaction of q D will depend
on the reaction of lD (nS ). In what follows, I will assume that the substitution
effect dominates the wealth effect on labor supply when the return to labor
changes. In this case, q D will be a decreasing function of Π.
From Figure 8.1, it is clear that an increase in z will serve to make the
budget constraint “steeper.” Since I have assumed that the substitution effect
dominates the wealth effect, this increase in the return to labor will increase
nS (decrease lD ). This effect alone will serve to increase the real demand for
money. But there is an added effect as well. Since an increase in z increases
wealth, the demand for future output cD also increases owing to a positive wealth
effect. As future consumption can only be acquired by first accumulating cash
balances, the demand for money increases for this reason (even if nS was to
remain unchanged).

Exercise 8.1: Is there any logic in labeling c a “cash good” and l a “non-cash good?”
Explain how an expected inflation affects the relative price of cash goods vis-à-
vis non-cash goods.

Exercise 8.2: Suppose that the preferences of a representative young agent are de-
scribed by the utility function u(l, c) = ln(l) + βc, where β ≥ 0 is a preference
parameter. For these preferences, M RS(l, c) = 1/(βl). Demonstrate that the
demand for real money balances is in this case given by:
Π
q D (z, Π) = z − .
β
Note that for these preferences, if the expected inflation rate is “too high,” then
the demand for money will be zero. What is the upper bound on inflation here?

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