Conclusion

In this chapter, we have analyzed the role and functions of money and the determination of the price level, nominal interest rates, and inflation.

Money performs three functions.

We reviewed the basic functions of money and the factors that determine the demand for and supply of money. We analyzed the concept of short-run equilibrium in the money market, assuming that the central bank follows a policy of either targeting the money supply or pegging nominal interest rates. We also discussed the long-run neutrality of money.

We then focused on several dynamic general economic equilibrium models with money, to analyze the determination of the price level and nominal interest rates and also analyzed the long-run relationship between the money supply, the price level, and inflation.

We finally examined the fiscal incentive for increasing the money supply and its effects on inflation. The most important motive for sustained large increases in the money supply by governments has been to finance government expenditure that could not be financed by other methods, such as additional taxes or government bonds. This source of revenue for the government is called seigniorage. The main cause of all episodes of sustained high inflation or even hyperinflation has been the need of governments to use their privilege of printing money to obtain seigniorage.

We investigated the relationship between the growth rate of the money supply, inflation, and government revenue from seigniorage. We examined both the situation where the revenues from seigniorage are adequate for the needs of a government on the balanced growth path, a case in which inflation turns out to be high but stable, and the situation in which the required seigniorage revenues are not sufficient, which may lead to hyperinflation.

1. For an advanced up-to-date textbook entirely devoted to monetary theory and policy, see Walsh [2017].

2. See Mishkin [2016, chapter 3] for a more detailed discussion of alternative definitions of money.

3. See Goodhart [1988], Capie et al. [1994], and Fischer [1994], for the evolution of the role of central banks.

4. There is an extensive literature on the transmission mechanisms of monetary policy in economies with developed financial and fiscal systems, going back at least to Fisher [1896] and Wicksell [1898]. The views of Keynes, as they evolved, can be found in Keynes [1923, 1936]. The views of the Keynesians are summarized in the IS-LM framework of Hicks [1937]. A more sophisticated Keynesian view is Tobin [1969], and the dominant monetarist view is Friedman [1970]. The subsequent literature is extensive. See, for example, Friedman [1975], Modigliani and Papademos [1980], Papademos and Modigliani [1983], Mishkin [1995], Taylor [1995], Bernanke and Gertler [1995], and Meltzer [1995], for a variety of views about the transmission mechanism. In what follows, and until chapters 19 and 20, we shall focus on a simplified monetary policy transmission mechanism that depends on the effects of changes in the money supply on nominal and real interest rates and asset prices, through open market operations. Other channels, such as the credit channel, will be discussed when we discuss financial frictions in chapter 19.

5. A demand for money in this form was first introduced by Keynes [1936] and was termed liquidity preference. The classic optimizing partial equilibrium models of money demand for transaction purposes, which also depend on the nominal interest rate, are due to Baumol [1952] and Tobin [1956]. The restatement of the quantity theory of money by Friedman [1956] also results in money demand functions that depend on interest rates.

6. The quantity theory equation is the basis of the quantity theory of money, which states that, in the long run, the general price level of goods and services is directly proportional to the amount of money in circulation.

7. See Friedman [1956] and Friedman and Schwartz [1963].

8. See Pigou [1941] for an early exposition of this viewpoint.

9. In chapter 7 we analyzed the Blanchard-Weil OLG growth model, with money in the utility function of households, and showed that in such a model, the superneutrality of money does not hold.

10. See Woodford [1990] for a survey of the evolution of the literature on this issue.

11. As Sargent and Wallace [1975] were the first to recognize, this indeterminacy was first alluded to by Wicksell [1898], in the context of a static monetary model with flexible prices.

12. In fact, Wicksell suggested that the interest rate should change when the price level deviates from the target price level, as he was fully aware of the difficulties in calculating the natural rate of interest. In our treatment here, it is assumed that the natural real interest rate is constant and fully known. As will be seen in chapter 20, uncertainty about the natural rate of interest (or indeed, other variables) entails additional difficulties for monetary policy.

13. The same analysis can be carried out in the context of equation (12.71), the money market equilibrium condition of the representative household model with money in the utility function.

14. Apart from the study of Cagan [1956], for the hyperinflation episodes of the interwar period and World War II, see Sargent [1982] on how four hyperinflation episodes ended. More recent episodes of high inflation and hyperinflation have been discussed by Sachs and Larrain [1993, chap. 23] and Fischer et al. [2002].

15. Alternatively, we could assume that the real interest rate equals ρ + g, as would apply on the balanced growth path of a representative household model with logarithmic preferences. In this case, the nominal interest rate would be equal to ρ − n + μ. The results of the analysis would not change, as in periods of high inflation and hyperinflation, the growth rate of the money supply is much higher than the difference between the pure rate of time preference ρ and the population growth rate n.

16. The term”Laffer curve” derives from Arthur Laffer, an economist who claimed, in a meeting with US administration officials in 1974, that tax revenue after a point becomes a negative function of tax rates, because of the disincentive effects of high taxes. He famously sketched this curve on a napkin in the venue where the meeting took place (Wanniski [1978]). Laffer himself notes antecedents in the writings of the fourteenth-century social philosopher Khaldun and in Keynes (Laffer [2004]).