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Nicola Viegi
August 2010
Monetary Economics ()
Lecture 2
August 2010
1 / 17
Introduction
Roles of money: medium of exchange, unit of account, and storage of value (often dominated by other assets). Money is macro model is typically identied with currency which gives no interest. The liquidity service of money ( medium of exchange) is emphasized, rather than store of value or unit of account. General Equlibrium models (Like RBC models) do not require money to specify a model with money we need to give it a function Agent will demand money only if it has a use
Monetary Economics ()
Lecture 2
August 2010
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Modelling Money
Cagan Model - The Price of Money Money in Utility Function Approach Cash in Advance Models
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Lecture 2
August 2010
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Originally a model of Hyperination Main Point: Expectation about future fundamentals determine prices now Used extensively in Exchange rate analysis, assets prices A lot of modern models look like this
Monetary Economics ()
Lecture 2
August 2010
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The Model
(1 + it ) = (1 + rt )
log approximation and uncertainty
Pt +1 Pt
log (1 + it ) = log (1 + rt ) + Et pt +1
pt
Monetary Economics ()
Lecture 2
August 2010
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pt = pt =
(Et pt +1 (Et pt +1
pt ) pt )
mt or pt =
1 mt + Et pt +1 1+ 1+
Monetary Economics ()
Lecture 2
August 2010
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Forward Solution
pt
= = =
1 mt + Et pt +1 1+ 1+ 1 1 mt + Et mt + 1 + Et +1 pt +2 1+ 1+ 1+ 1+
2 1 mt + Et m t + 1 + Et pt +2 1+ 1+ 1+ = ......... s T 1 T 1 mt + s + Et pt +T = 1 + s 1 + 1+ =0
(1)
Monetary Economics ()
Lecture 2
August 2010
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T !
Et pt +T = 0 1+
s
1 T ! 1 + lim
s =0
mt + s <
Monetary Economics ()
Lecture 2
August 2010
8 / 17
Solution
Generic Solution pt = 1 1+
s =0
1+
mt + s
Prices at time t depend on all future expected money supply. Expected fundamentals (not actual)
pt e
Monetary Economics ()
Lecture 2
August 2010
9 / 17
mt m Et m t + s = m
(s
0)
s
pt
= =
1 1+ 1 + s =0 1 1 m 1 + 1 1 +
= m
Monetary Economics ()
Lecture 2
August 2010
10 / 17
Consider an surprise announcement at time t = 0 of a change of policy at some time in the future T > 0 m t<T m0 > m t T
mt = Thus
pt =
m t<T m0 t T
Monetary Economics ()
Lecture 2
August 2010
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Solution
T
s
pt pt pt
s =0
1+ 1+
T t
m+
T
1 1+
s =T
t s
1+ m0 m
m0
= m+ = m+
1 1+ 1+
s =0
1+
m0
Monetary Economics ()
Lecture 2
August 2010
12 / 17
Solution
log price level
p0
m
time
Prices "Jump" at the announcement, before the policy is implemented Expectations drive economic dynamics
Monetary Economics () Lecture 2 August 2010 13 / 17
Seignorage
St Rewrite St Mt Mt Pt
1
Mt
Mt Pt
Mt Pt
Mt Pt
1 1
Mt Pt
1 1
Mt 1 Pt
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Lecture 2
August 2010
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Optimal Seignorage
Mt
Mt Pt
Mt
Mt Mt
Mt Pt
Mt = Pt
Pt +1 Pt
Mt Pt = (1 + ) = Mt 1 Pt 1
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Lecture 2
August 2010
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Optimal Seignorage
Constant Seignorage S FOC dS = (1 + ) d
(1 + ) (2 + )
(1 + ) (1 + )
= (1 + )
(1 + )
0 =
(1 + ) (1 + )
(2 + )
opt
= [1 + 1 =
(1 + )] (1 + )
Monetary Economics ()
Lecture 2
August 2010
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Cagan puzzle
Under hyperination, actual money growth much higher (wrong side of Laer curve). Obstfeld-Rogo: Absence of commitment, time-consistency problem? Promise = 1/ ) M/P = [(1 + )/ ] . For given M/P , S = (M/P )/(1 + ). Temptation to one-time increase in . New equilibrium under discretion, smaller M/P, higher . Note: Other budgetary consequences of surprise ination (value of outstanding nominal debt). Seignorage in industrialized countries small relative to government spending and GDP (less than 1% of GDP) (Obstfeld-Rogo, box 8.1) Seignorage more important in developing countries
Monetary Economics ()
Lecture 2
August 2010
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