Quest ion 10

I n an econo1ny w it h n households, assu 1ne a household 's utility d e p ends on the

quantity of goods consumed , X , and on r eal money balances , M / P.
u = xlf a(M / P )lf a
Let the household have initial e ndowments X o of goods and M o of no1ninal n1oney
balances. The budget constraint face d by the household is then , in nominal terms:

PX+ M< P X 0 + Mo.

(a) What is a potential justification of the incl usion of money in the utility function?
(7 points)
(b) Is 1noney n e utral in this economy? D iscuss analytically.
(7 points)
( c) If the economy was characterised by lilnited participation in financial market s
,vould your r esults change? P rovide intuition without deriving the model.
(6 points)
(a) Assume that individual's utility depends also on the level of real money balances and
consumption. The justification, according to Patinkin, is that even if households plan to
balance t heir budgets so that planned purchases are equal in value to planned sales, it may
be convenient to buy and sell goods at different t imes. The more n1oney they hold , the
greater t he extent to which t hey can purchase goods ahead of 1naking sales. Money holdings
stand as a proxy for t he 1nore convenient sequence of transactions they make possible. Thus,
money is in t he utility function.
(b) Assume a household's utility depends on the quantity of goods consumed, X, and on real
money balances, M/ P. Let t he household have init ial endowments X o of goods and Mo of
nominal money balances. The budget constraint faced by the household is t hen, in nominal
terms:
PX + M < PXo +Mo.
So that the nominal expendit ure on goods, PX , plus the holdings of nominal n1oney
balances, M , must not be greater than t he nominal value of t he endowments of goods and
money. \i\Triting t he budget constraint in real terms (dividing by the price level) gives:
lvf Mo
X+p <Xo +y•
The household 's ut ility function takes the specific form U = X 112 (J'vl / P ) 112 . In order to
detennine the demands for goods and real money balances, we maximise the utility function
subject to the budget constraint . To do this we forn1 the Lagrangian (we also in1pose an
equality in the budget constraint as this inlplies no wastage of goods or money):

L=X I 12 (A1)
p
11 2
I
Mo -
+ A ( X0 + p X - pM) .
Differentiating with respect to the two choice variables, X and !VI/ P , gives the first order
conditions of:
1/ 2
dL . !.x-1/2( !VI - A= 0
clX 2 p )

dL
d(M/ P)
from which we obtain:
Substituting into the budget constraint will give solutions for the demands for goods and
nominal money balances of:

X = Xo+Mo / P and M = PX0 + 1\!Io_

2 2

Assume now that the economy consists of n households each identical to the one described
above. The market clearing condition in the goods market then becomes:

In other words, total demand equals total supply. Solving for the p rice level gives:
Alternatively, we can write down the market clearing condition for the money market:

n (
PX
02
+ lv/0 ) = rd\llo .

If we solve for the price level here, we obtain:

In this economy, money is neutral. Real output per household is fixed at X 0 as it depends
on endowments. From the solut ion of the price level, a change in the money supply will only
lead to a proportional increase in prices. R.eal money balances and 'production' of goods do
not change. An increase in money, Mo, will shift the demand function for good X outwards
in Figure 4.2 of the subject guide but this simply causes the price level to increase.
(c) Nlonetary policy may have real effects if there are a li1nited number of agents participating
in financial markets. If the monetary authorities decided to increase the money stock, such
policy actions would be made through banks and other financial intermediaries with whom
the open market operations were conducted. Now faced with a glut of liquid assets, banks
wish to lend out some of these in order to maintain their desired reserve ratio. The increase
in the supply of loans will cause the interest rate charged on these loans to fall (the liquidity
effect) and since firms borrow from financial intermediaries to finance investment projects,
t his makes investment cheaper. Cheaper investment ca.uses investment to increase, which
therefore causes output, and employment if Labour and capital are complementary inputs, to
increase.
Question 9

Consider a classical-Patinkin economy where a representative household utility is a

function of consumption (C) and real 1noney balances (M / P ) such t h at:

U = C°'(lvI / P )1 - °',
and the household is subject to a budget constraint given by:

C + l\ll/ P < Y + M 0 / P ,
where Y stands initial endow111ent of goods, Mo stands for initial 111oney balances.

(a) Calculate opti111al goods and money demand. Provide intuition. Would your
results change qualitatively if elements (that are real 1noney balances and
consumption) in the utility function were additive, instead of 1nultiplicative?
(b) Is there a role for 1nonetary policy in this setting? What happens when the
econo111y faces a money supply increase? Sho,v graphically and provide intuition.
( c) Is the classical theory convincing? Are you aware of alternative macro theories
where monetary policy can be an effective output stabilisation tool? D iscuss
analytically one such n1odel.
(a) Here we assume that the utility depends not only on goods consumption but also on the
level of real money balances. The justification, due to Patinkin, is that even if households
plan to balance their budgets so that planned purchases are equal in value to planned sales,
it n1ay be convenient to buy and sell goods at different tunes. The more money they hold,
the greater the extent to which they can purchase goods ahead of making sales. ivloney
holdings stand as a proxy for the more convenient sequence of transactions they 1nake
possible. Thus, money is in the utility function.
Assume a household's utility depends on the quantity of goods consmned, X , and on real
money balances, 1Vf/ P. Let the household have init ial endowments Y of goods and l\lfo of
nominal 1noney balances. The budget constraint faced by the household is t hen, in nominal
terms:
PX + M < PY + Mo . (.1)
So that t he nominal expendit ure on goods, PX, plus the holdings of nominal n1oney
balances, M , must not be greater than t he nominal value of the endowments of goods and
money. vVriting t he budget constraint in real t erms (dividing by t he price level) gives:

(.2)

For t he sake of simplicity we assume t hat a< 1/ 2. Then, t he household's ut ility function
takes the specific form U = X 112 (M / P ) 112 . In order to detennine t he demands for goods
and real money balances, we maximise t he utility function subject to the budget constraint.
To do this we form t he Lagrangian (we also impose an equality in t he budget constraint as
t his implies no wastage of goods or money) :

(.3)
Differentiating with respect to the two choice variables, X and l\ll/ P , gives the first order
conditions of:
1/2
clL
~x-1/ 2 ( ~) - >. = O (.4)
dX
dL M)-1/2
..!.x1/2 - - >. =0 (.5)
cl(Jvf/ P) 2 ( p

from which we obtain:

(.6)
Substituting into the budget constraint will give solutions for the demands for goods and
nominal n1oney balances of:

X = Y+Mo / P and M = PY+Mo _ (.7)

2 2
Assume now that t he economy consists of n households each identical to t he one described
above. The market clearing condition in the goods market then becomes:

Y + 7/1.fo )
n = nY. (.8)
( 2
In other words, total demand equals total supply. Solving for the price level gives:

P = Mo (.9)
y·
Alternatively, we can write down the market clearing condition for the money market:

-+Mo
P}'
n (- - - ) -- n M o- (.10)
2

If we solve for t he price level here, we obtain:

P = Mo (.11)
y·
In this economy, money is neutral. Real output per household is fixed at Y as it depends on
endowments.
Modifying the ut ility function such that elements are additive (i.e. such that
U = X 1 12 + (M / P )112 ) does not change the result .
(b) Fron1 the solut ion of t he price level, a change in the money supply will only lead to a
proport ional increase in prices. R.eal money balances and 'production' of goods do not
change. An increase in money, Mo , will shift the den1and function for good X outwards in
Figure 4.2 of the subject guide but this simply causes t he price level to increase.
(c) In standard classical models money is just a veil, while we know that money may have real
effects at least in the short run. However, it is possible even with the classical paradig1n to
obtain short term real effects of money. There are a v-ride range of alternatives here.
Candidates could solve Lucas' misperceptions model or a simple cash in advance model for
cases of classical model or a I{eynesian (such as McCallum) model to make their point.
Question 11

Con sid er a classical Patinkin econom y where a representat ive household utility is a
function of consumption, C, and real money balances, M / P , such that:

Ut = c; (
M
Ptt
)1-a
and the household is subject to a budget constraint given by:

Yt is the endo':"m ent and Mt-l are the money balances accr ued in the previous
period.

(a) What is the justification of adding money balances to the utility function?
(6 marks)
(b) Calcula t e optimal good s and money demand. P r ov ide intuition. I f elements in
the utility function were additive of t he form:
1
M ) -a:
Ut = C~ + ( Ptt

instead of multiplicative, would your results change qualitatively? Discuss

briefly using the new fir st-order conditions.
(8 marks)
(c) Is there a role for monetary policy in this setting? What happens when the
economy faces a mon ey s u pply increase? Show gr aphically and provide intuit io n .
(6 marks)
(a) Assun1e that an inclividual's utility depends also on the level of real 1noney balances and
consumption. The justification, according to Patinkin, is that even if households plan to
balance their budgets so that planned purchases are equal in value to p lanned sales, it may
be convenient to buy and sell goods at different times. The more money they hold, the
greater the extent to which they can purchase goods al1ead of making sales. l\!Ioney holdings
stand as a proxy for the more convenient sequence of transactions they make possible.
Therefore, money is in the utility function.

(b) In order to detennine the demands for goods and real money balances, we maximise the
utility function subject to the budget constraint. To do this we form the Lagrangian
(imposing t he equality constraint as the utility function is non-satiated). Asslilme that
a = 1/2 and that Yt reflects initial endowment of consumption of goods. We have:
11 2
1 2 0
£ =c 1 ( ~) + >. (Co+ ~ - C - ;) .

Differentiating with respect to the two choice variable,s, C and M / P , gives the first-order
conclitions of:
d£ = ! c-1/2
dC 2 P
(NI)
1; 2 - >. = 0

and:
d£ = ! c1/ 2 (NI)-1; 2 - >. = 0
d(NI/P) 2 P
from which we obtain:
C = NI
p·
Substituting into the budget constraint will give solutions for the demands for goods and
nominal money balances of:

C = Yo+Mo/ P and M = PCo + 1\10 .

2 2
Assume now that the economy consists of n households each identical to t he one described
above. The market-clearing condition in the goods market then becomes:

Co+ l\lfo/ P) _ y,
n ( 2 - n O·

In other words, total demand equals total supply. Solving for the price level gives:

P = Mo_
Yo
Alternatively, we can write down the market-clearing condition for the money market:

n (
PYo +
2
1110) -_n M O·
 If we solve for the price level here, we obtain:

P = !1110 •
Yo
In this economy, money is neutral. Real output per household is fixed at Y0 as it depends on
endown1ents . .F):om the solution of the price level, a change in the money supply will only
lead to a proportional increase in prices. Real money balances and 'production' of goods do
not change. An increase in money, At[0 , will shift the deinand function for good Y out\1-1ards
in Figure 4.2 of the subject guide, but this silnply causes the price level to increase.

(c) In this economy, money is neutral. Real output per household is fixed at X 0 as it depends
on endowments. From the solution of the price level, a change in the 1noney supply will only
lead to a proportional increase in prices. Real money balances and 'production' of goods do
not change. An increase in money, Jv10 , will shift the demand function for good X outwards
in Figure 5.2 of the subject guide, but this simply causes the price level to increase.