cash in adv slides

14.452. Topic 6.
Introducing money
Olivier Blanchard
April 2007
Nr. 1
Cite as: Olivier Blanchard, course materials for 14.452 Macroeconomic Theory II, Spring 2007.
MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].
1. Motivation
No role for money in the models we have looked at. Implicitly, centralized
markets, with an auctioneer:
• Possibly open once, with full set of contingent markets. (Remember, no

heterogeneity, no idiosyncratic shocks.) (Arrow Debreu)
• More appealing. Markets open every period.

Spot markets, based on expectations of the future. For example, market
for goods, labor, and one–period bonds. A sequence of temporary
equilibria (Hicks). (no heterogeneity)
Still no need for money. An auctioneer. Some clearing house.
Nr. 2
So need to move to an economy where money plays a useful role. The required
ingredients:
• No auctioneer. Geographically decentralized trades.
• Then, problem of double coincidence of wants. Barter is not convenient.

Money, accepted on one side of each transaction, is much more so.
Two types of questions:
Nr. 3
Foundations of monetary theory questions:
• Why money? What kind of money will emerge?

• Can there be competing monies? silver/gold. dollars/domestic currency.
• Fiat versus commodity money?
• Numeraire versus medium of exchange? Should they be the same, or

not?
Not just abstract, or history. The rise of barter in Russia in the 1990s. Dollar
ization in Latin America and hysteresis. “Units of account”, i.e. a numeraire
different from the medium of exchange, in Latin America.
But most of the time, we can take it as given that money will be used in
transactions, that it will be fiat money, and that the numeraire and the medium
of exchange will be the same.
Nr. 4
If we take these as given, then we can ask another set of questions:
• How different does a decentralized economy with money look like?

• What determines the demand for money, the equilibrium price level,
nominal interest rates?
• How does the presence of money affect the consumption/saving choice?
• Steady state and dynamic effects on real activity and inflation of changes
in the rate of money growth.
Start by looking at a benchmark model. Cash in advance (CIA).
Then, look at variations on the model; money in the utility function.
Then focus on price and inflation dynamics, especially hyperinflation.
Nr. 5
2. A cash-in-advance model
Ignore uncertainty (need to reintroduce it if look at unexpected changes in

money.
Also ignore the labor/leisure choice. This will make the basic structure of the
model much easier to understand.
The optimization problem of consumers

i=∞
�
β i U (Ct+i )
i=0
subject to:
Pt Ct +Mt+1 +Bt+1 +Pt Kt+1 = Wt +Πt +Mt +(1+it )Bt +(1+rt )Pt Kt +Xt
and
Pt Ct ≤ Mt + Xt
Nr. 6
Pt Ct + Mt+1 + Bt+1 + Pt Kt+1 = Wt + Πt + Mt + (1 + it )Bt + (1 + rt )Pt Kt + Xt
• Pt is the price of goods in terms of the numeraire (the price level).
• Mt , Bt , Kt are holdings of money, bonds, and capital at the start of

period t.
• Wt and Πt are the nominal wage and nominal profit received by each
consumer respectively. it is the nominal interest rate (in dollars, not
goods) paid by the bonds.
• rt is the rental rate (in goods) on capital. Money pays no interest.
• Xt is a nominal transfer from the government (which has to be there

if and when we think of changes in money as being implemented by
distribution of new money to consumers).
Nr. 7
Pt Ct ≤ Mt + Xt
• Consumers care only about consumption. Do not derive utility from

money.
• The first constraint is the budget constraint in nominal terms.
• If the only constraint was the first, then people would hold no money:
Bonds pay interest, capital pays a rent, money does not.
The second constraint explains why people hold money. Known as the
cash in advance (CIA) constraint. People must enter the period with
enough nominal money balances to pay for consumption.
• One potential story: Households: a worker and a consumer. The worker

goes to work. The consumer goes to buy goods, before the worker has
been paid.
• More sophisticated formulations? For example: The cost of buying
consumption goods decreasing in money balances. Return to this below.
Nr. 8
Let λt+i β i be associated with the budget constraint (the shadow value of
wealth), µt+i β i be associated with the CIA constraint (the shadow value of
liquidity). Set up the Lagrangian and derive the FOC.
� 1
Ct : U (Ct ) = (λt + µt )Pt ⇔ ( Ct = λt + µt )
Pt
Mt+1 : λt = β(λt+1 + µt+1 )
Bt+1 : λt = β(1 + it+1 )λt+1
Kt+1 : λt Pt = β(1 + rt+1 ) λt+1 Pt+1
Nr. 9
We can manipulate these conditions to get an intertemporal condition on the
marginal utility of consumption:
From the third and the fourth:
Pt+1
(1 + it+1 ) = (1 + rt+1 ) = (1 + rt+1 )(1 + πt+1 )
Pt
From the first and second:

U � (Ct+1 ) U � (Ct+2 )
λt = β λt+1 =β
Pt+1 Pt+2
Replacing in the third:
U � (Ct+1 ) U � (Ct+2 )
= β(1 + it+1 )
Pt+1 Pt+2
Divide both sides by (1 + it+1 ) , and then multiply and divide the second term
by (1 + it+2 ), to get:
Nr. 10
U � (Ct+1 ) U � (Ct+2 )
= β(1 + rt+2 )
1 + it+1 1 + it+2
Interpretation:
• Because people have to hold money one period in advance, the effective
price of consumption is not 1 but 1 + i.
• Once we adjust for this price effect, get the same old relation, between
marginal utility this period, marginal utility next period, and the real
interest rate.
• Note the role of both the nominal and the real interest rates.
• Note that if the nominal interest rate is constant, the equation reduces
to the standard Euler equation (Why not Ct and Ct+1 ?)
U � (Ct+1 ) = β(1 + rt+2 )U � (Ct+2 )
Nr. 11
Turn to the characterization of money demand. From the second and third
condition:
µt+1 = it+1 λt+1
So as long as the nominal interest rate is positive, µ will be positive, and so:
Mt + Xt
= Ct
Pt
Pure quantity theory. No interest rate elasticity.
Nr. 12
Equilibrium
• Assume firms rent capital and labor, so
Pt FN (Kt , Nt ) = Wt FK (Kt , Nt ) = rt − δ
• Given constant returns and competitive markets, pure profit Πt = 0
• Employment, Nt is equal to 1 (inelastic supply)
• Money introduced through lump sum transfers to consumers (“helicopter

drops”). (Alternative: Money used by the government to buy goods).
Mt+1 − Mt = Xt
• As bonds are issued by agents (not firms, renting capital and labor
services) and all agents are identical, in equilibrium, there are no bonds
outstanding
Bt+1 = Bt = 0
Nr. 13
Replacing all these conditions in the accumulation equation of consumers-
workers gives:
Pt Ct + Pt Kt+1 = Pt FN (Kt , 1) + (1 + FK (Kt , 1) − δ)Pt Kt
Or, dividing by Pt , and reorganizing:
Kt+1 = F (Kt , 1) + (1 − δ)Kt − Ct
So, exactly the same condition as in the non monetary economy.
Nr. 14
Putting the relevant equations together:
U � (Ct+1 ) U � (Ct+2 )
= β(1 + rt+2 )
1 + it+1 1 + it+2
(1 + it ) = (1 + rt )(1 + πt )
(1 + rt ) = 1 − δ + FK (Kt , 1)
Mt + Xt
= Ct
Pt
Kt+1 = F (Kt , 1) + (1 − δ)Kt − Ct
Nr. 15
Steady state
Let growth of nominal money be x, so (Xt /Pt ) = x(Mt /Pt ) From the FOC
of the consumers, and the demand for capital by firms:
(1 + r) = 1 + FK (K, 1) − δ = 1/β
Same as without money: Modified golden rule.

Using these relations in the budget constraint gives:
C = F (K, 1) − δK
Money growth has no effect on activity. Superneutrality

In steady state, real money balances must be constant, so:
π=x
Inflation is equal to money growth. And so, i = π + r = x + r. Fisher

effect (from Irving Fisher).
Nr. 16
Dynamics
• Harder to characterize. Come from the consumption wedge. x → π →

i. Easy however to guess the solution to simple paths for money.
• An unexpected permanent increase in money leads to an equal propor

tional increase in the price level, and no change in the real variables.
• An unexpected permanent increase in money growth, from x to x� . In
this case, this leads to a proportional increase in the price level today,
and inflation at rate x� from then on. Nominal interest rates increase
by x� − x. Real variables are unaffected.
• Any path that generates a decrease in the interest rate and an increase
in consumption in response to an increase in nominal money growth?
(Stylized facts) Not obvious:
Think temporary increase in money growth: temp increase in inflation,
in nominal rates. Temporary decrease in consumption.
Nr. 17
Conclusions
• We have seen how we can introduce money as a medium of exchange in

GE models. The monetary economy does not look very different from
the economies we had looked at until now.
• The consumption/saving choice is modified, but not transformed. There
is now a demand for money is a function of transactions.
• The real effects of money are limited. In steady state, money is not only
neutral, but superneutral
• Changes in money may have dynamic effects on real variables. But these
effects appear to be limited.
Nr. 18
Extensions
• The CIA model we looked at had an extremely simple cash in advance

constraint.
• More general ones, with money demand function of interest rate. GE

version of Baumol Tobin, by Romer (See BF, Chapter 4)
• Baumol-Tobin: Households decide how often to go to the bank to ex

change money for bonds. The higher the interest rate, the more often
they go, the lower their average real money balances.
• In these models, changes in money have distributional effects (between
those who go to the bank and those who do not) and thus effects on
real activity. But effects appear limited (and exotic).
• CIA models can become very unwieldy. Short cuts? Money in the utility
function.
Nr. 19
3. Money in the Utility function
Consider the following optimization problem (Sidrauski model):

Consumers/workers maximize:
� Mt+i
β i U (Ct+i , )
Pt+i
subject to:
Pt Ct + Mt+1 + Bt+1 = Wt + Πt + Mt + (1 + it )Bt + Xt
(Consumers/workers own the firms)
Think of the utility function as a reduced form of a more complex problem in

which by holding more money, households can shop more efficiently, increase
leisure time, and so on.
Plausibly Um > 0 and Umc ≥ 0 (why?).
Nr. 20
First order conditions
For simplicity, ignore uncertainty. Let λt+i β i be the lagrange multiplier asso
ciated with the constraint. Then the FOC are given by:
Mt
Ct : Uc (Ct , ) = λt Pt
Pt
Bt+1 : λt = λt+1 β(1 + it+1 )
1 Mt+1
Mt+1 : λt = β[λt+1 + Um (Ct+1 , )]
Pt+1 Pt+1
Nr. 21
Rewrite as:
An intertemporal condition:
Mt Mt+1
Uc (Ct , ) = β(1 + rt+1 )Uc (Ct+1 , )
Pt Pt+1
An intratemporal condition
Mt Mt
Um (Ct , )/Uc (Ct , ) = it
Pt Pt
Ratio of marginal utilities has to be equal to the opportunity cost of holding
money, so i, the nominal interest rate.
Nr. 22
If for example,
U (C, M/P ) = log(C) + a log(M/P )
(not an appealing assumption, as Ucm = 0, but very convenient) Then,
(1/Ct ) = β(1 + rt+1 )(1/Ct+1 )
(Mt /Pt ) = a(Ct /it )

This gives us an IS and an LM relation.
• The IS: the higher the interest rate, the lower consumption given ex
pected consumption in the future.
• The LM: The demand for money is a function of the level of transactions,
here measured by consumption, and the opportunity cost of holding
money, i.
Under these assumptions, no distortion in the intertemporal consumption de

cision.
Nr. 23
Steady state
The firms’ side is the same as before, so:
1 + FK (K, 1) − δ = 1/β
C = F (K, 1) − δK
M M
Um (C, )/Uc (C, ) = (x + r)
P P
So, same real allocation again. Superneutrality of money. And a level of real
money balances inversely proportional to the rate of inflation, itself equal to
the rate of money growth.
Nr. 24
What is the optimal rate of money growth?
• As money is costless to produce, the optimal rate is such as to drive the

marginal utility of real money to zero, so to drive i = x + r to zero.
• In other words, it is to have x = −r: Money growth—or inflation—

negative and equal to minus the marginal product of capital.
• This result is known as the Optimum Quantity of Money (the
semantics are not great, as this is a result about money growth, not
level.)
Nr. 25
Dynamics and conclusions
• Dynamic effects of changes in money on real activity? In general, yes,

but limited. (see next slides)
• And nothing which looks like the real effects of money in the real world.
• Bottom line: Money as a medium of exchange, without nominal rigidities

gives us a way of thinking about the economy, the price level, the nominal
interest rate, but not much in the way of explaining fluctuations.
• Very useful however when money growth and inflation become high and
variable. Turn to this.
Nr. 26
[A simulation of the Sidrauski model]
• Utility function given by:
1 1−σ
1−b 1−b 1/(1−b)
U (Ct , mt ) = [(aCt + (1 − a)mt ) ]
1−σ
• 1/b elasticity of substitution between C and m, equal to 1/16. σ = .5,
a = .975. (UCm > 0 if b > σ).
• Effects of an increase in the rate of nominal money growth of 1%,

returning to normal at rate .8 per period.
• Interpretation of results. Why does consumption go down? What would

happen to labor supply if it were endogenous.
Nr. 27
0.12 3 0.45 0.2 0.1
inflation nominal r money
0.4 0
0
0.1 2.5
−0.2
0.35
−0.1
−0.4
0.08 2 0.3
−0.2
−0.6
0.25
0.06 1.5 −0.8 −0.3
0.2
−1
−0.4
0.04 1 0.15
−1.2
−0.5
0.1
−1.4
0.02 0.5
−0.6
0.05 −1.6
capital
consumpti
0 0 0 −1.8 −0.7
0 5 10 0 5 10 0 5 10 0 5 10 0 5 10
Cite as: Olivier Blanchard, course materials for 14.452 Macroeconomic Theory II, Spring 2007. Nr. 28
3. Money growth, inflation, seignorage
Inflation and Money Growth during Seven Hyperinflations of the 1920s

and 1940s
Country Beginning End PT /P0 Av Monthly Av Monthly

Inf rate (%) M Growth (%)
Austria Oct. 1921 Aug. 1922 70 47 31
Germany Aug. 1922 Nov. 1923 1.0x1010 322 314
Greece Nov. 1943 Nov. 1944 4.7x106 365 220
Hungary 1 Mar. 1923 Feb. 1924 44 46 33
Hungary 2 Aug. 1945 Jul. 1946 3.8x1027 19,800 12,200
Poland Jan. 1923 Jan. 1924 699 82 72
Russia Dec. 1921 Jan. 1924 1.2x105 57 49
PT /P0 : Price level in the last month of hyperinflation divided by the price level
in the first month. Source: Philip Cagan, 1956.
Nr. 29
• Was hyperinflation the result of money growth, and only money growth?
• Why was money growth so high? Did it maximize seignorage (revenues

from money creation). And if not, then why?
• What was the role of fiscal policy?
Nr. 30
Start with the money demand in the spirit of that we have just derived:
Mt
= Ct L(rt + πte )
Pt
If money growth and inflation are high and variable, M , P and π e will move
a lot relative to C and r. So assume, for simplicity, that Ct = C, and rt = r,
so:
Mt
= C L(r + πte )
Pt
This gives a relation between the price level and the expected rate of inflation.
The higher expected inflation, the lower real money balances, the higher the
price level.
Nr. 31
Shift to continuous time, more convenient here. Assume a particular form for
the demand for money:
M/P = exp( −απ e )
So, in logs:
m − p = −α π e
Log real money balances are a decreasing function of expected inflation. Dif
ferentiating with respect to time:
x − π = −α dπ e /dt
Assume that people have adaptive expectations about expected inflation. (In
an environment such as hyperinflation, this assumption makes a lot of sense.
More on rational expectations below).
dπ e /dt = β (π − π e )
Nr. 32
Money growth and inflation
Suppose money growth is constant, at x. Will inflation converge to π = x?
Combine the two equations above to get:
β
dπte = (x − π e )
1 − αβ
• If αβ > 1, then unstable. Why? (x → π → dπ e → π, and so on)
• If αβ < 1, then the equilibrium is stable. Start with x > 0, and π = 0.

Then converge to π = π e = x.
Effects of an increase in x? Jump in π above the new x, then back to
new x over time. Why?
Cagan estimated α and β, found αβ < 1. Hyperinflation was the result of

money growth, not a bubble.
Nr. 33
Seignorage and money growth
What is the maximum revenue the government can get from money creation:
dM/dt dM/dt M
S≡ = = x exp(−απ e )
P M P
So, in steady state:
S = x exp(−αx)
So x∗ = 1/α
Much lower than the growth rates of money observed during hyperinflation.
But just a steady state result. Can clearly get more in the short run, when π e
has not adjusted yet. This suggests looking at dynamics: Given seignorage,
dynamics of money growth and inflation.
Nr. 34
Start from:
1
S = x exp(−απ e ) or π e =
(log(x/S)
α
For a given S, draw the relation between π e and x in π e , x space. Concave.
Can cross the 45 degree line twice, once if tangent, not at all if no way to
generate the required seignorage in steady state.
Which equilibrium is stable? Using the equation for adaptive expectations and
the money demand relation in derivative form:
dπ e /dt = β/(1 − αβ) (x − π e )

If αβ < 1, and if two equilibria, lower one is stable. Start from it (A), and
suppose S increases so no equilibrium (go below G’G’). See Figure.
Then, money growth and inflation will keep increasing. This appears to capture
what happens during hyperinflations.
Nr. 35
Dynamics of seignorage and inflation
ʌe
ʌe = x
ab<1
B
GG
G’G’
Max ss seignorage
G”G”
A A’
S S* S** x
Nr. 36
Nominal Money Growth and Seignorage, during hyperinflations.
Rate of Money Growth Implied Actual Rate of

Maximizing Seignorage Seignorage Money Growth
(% per month) (% of output) (% per month)
Austria 12 13 31
Germany 20 14 314
Greece 28 11 220
Hungary 1 12 19 33
Hungary 2 32 6 12,200
Poland 54 4.6 72
Russia 39 0.5 49
Monthly rate of nominal money growth, in percent.
Nr. 37
Some other issues
• Adaptive or rational expectations? (see BF 5-1) Recent work by Sargent.

Learning.
• Fiscal policy, and the effects of inflation on the need for seignorage. (See
Dornbusch et al) Inflation may itself reduce revenues.
• “Unpleasant monetarist arithmetic?” (see BF 10-2) For a given deficit,

government can finance by debt or money. Which will lead to more
inflation today?
Nr. 38
Summary
• Need to introduce money for transactions. CIA constraints. but can get
complicated.
• Shortcut. (Real money) in the utility function.
• Nominal interest rates affect the demand for money, real interest rates
affect the slope of consumption.
• Money often superneutral. Real effects from dynamics do not resemble

what is in the data.
• Money growth central to inflation, hyperinflation. The strong link be

tween fiscal policy and monetary policy.
Nr. 39

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14.452. Topic 6.

• Possibly open once, with full set of contingent markets. (Remember, no

• More appealing. Markets open every period.

• No auctioneer. Geographically decentralized trades.

• Then, problem of double coincidence of wants. Barter is not convenient.

Two types of questions:

• Why money? What kind of money will emerge?

• Numeraire versus medium of exchange? Should they be the same, or

• How diﬀerent does a decentralized economy with money look like?

Start by looking at a benchmark model. Cash in advance (CIA).

Then, look at variations on the model; money in the utility function.

Then focus on price and inﬂation dynamics, especially hyperinﬂation.

Ignore uncertainty (need to reintroduce it if look at unexpected changes in

The optimization problem of consumers

• Pt is the price of goods in terms of the numeraire (the price level).

• Mt , Bt , Kt are holdings of money, bonds, and capital at the start of

• Xt is a nominal transfer from the government (which has to be there

• Consumers care only about consumption. Do not derive utility from

• One potential story: Households: a worker and a consumer. The worker

Mt+1 : λt = β(λt+1 + µt+1 )

Bt+1 : λt = β(1 + it+1 )λt+1

Kt+1 : λt Pt = β(1 + rt+1 ) λt+1 Pt+1

From the ﬁrst and second:

Replacing in the third:

U � (Ct+1 ) = β(1 + rt+2 )U � (Ct+2 )

µt+1 = it+1 λt+1

• Assume ﬁrms rent capital and labor, so

• Given constant returns and competitive markets, pure proﬁt Πt = 0

• Employment, Nt is equal to 1 (inelastic supply)

• Money introduced through lump sum transfers to consumers (“helicopter

Pt Ct + Pt Kt+1 = Pt FN (Kt , 1) + (1 + FK (Kt , 1) − δ)Pt Kt

Or, dividing by Pt , and reorganizing:

Kt+1 = F (Kt , 1) + (1 − δ)Kt − Ct

So, exactly the same condition as in the non monetary economy.

Same as without money: Modiﬁed golden rule.

Money growth has no eﬀect on activity. Superneutrality

Inﬂation is equal to money growth. And so, i = π + r = x + r. Fisher

• Harder to characterize. Come from the consumption wedge. x → π →

• An unexpected permanent increase in money leads to an equal propor­

• We have seen how we can introduce money as a medium of exchange in

• The CIA model we looked at had an extremely simple cash in advance

• More general ones, with money demand function of interest rate. GE

• Baumol-Tobin: Households decide how often to go to the bank to ex­

Consider the following optimization problem (Sidrauski model):

Pt Ct + Mt+1 + Bt+1 = Wt + Πt + Mt + (1 + it )Bt + Xt

(Consumers/workers own the ﬁrms)

Think of the utility function as a reduced form of a more complex problem in

Bt+1 : λt = λt+1 β(1 + it+1 )

(1/Ct ) = β(1 + rt+1 )(1/Ct+1 )

(Mt /Pt ) = a(Ct /it )

Under these assumptions, no distortion in the intertemporal consumption de­

The ﬁrms’ side is the same as before, so:

• As money is costless to produce, the optimal rate is such as to drive the

• In other words, it is to have x = −r: Money growth—or inﬂation—

• Dynamic eﬀects of changes in money on real activity? In general, yes,

• Bottom line: Money as a medium of exchange, without nominal rigidities

• Utility function given by:

• Eﬀects of an increase in the rate of nominal money growth of 1%,

• Interpretation of results. Why does consumption go down? What would

• An unexpected permanent increase in money leads to an equal propor

• Baumol-Tobin: Households decide how often to go to the bank to ex

Under these assumptions, no distortion in the intertemporal consumption de

• Money growth central to inﬂation, hyperinﬂation. The strong link be