Teoria y Politica Monetaria: Greatest Hits I

• Goal of the class: try to understand the link between monetary policy and inflation, exchange rate behavior, real activity.
  In particular, try to address the questions:
  • why do hyperinflation start (Latin America in the 80's)?
  • how are hyperinflations stopped (Latin America in the early 90's)?
  • why do financial crises occur (Latin America and Asia in the mid-90's)?
  • how can governments prevent financial crises from occurring?
• the first classes were spent trying to understand the behavior of prices
  • as a mean to understand prices we first studied the determination of stock prices
  • because money, like stocks, is a financial asset
  • therefore its value is determined in a forward looking manner: like the value of stocks depends of the present discounted value of all future dividends, the value of money depends on the present discounted value of ...
  • we drew on the analogy between money and durable goods
  • the value of a durable goods is given by the present discounted value of the services it provides
  • where the discount rate depends on whether the services provided by the durable good and the consumption good are substitutes or complements in utility
  • the value of money (the price level) is given by the present discounted value of the services it provides
• what kind of services does money provide?
  • medium of exchange
  • store of value
  • unit of account
• cash in advance model: money provides services as a medium of exchange (but is also store of value, and unit of account), because it makes it possible to buy cash goods
• the service provided by money consists in relaxing the cash in advance constraint of the household, allowing her to choose between cash (cappuccino's) and credit goods (airplane ticket)
• the fact that money provides a service to household implies that money -indirectly- enters the utility function
• Sidrauski-Brock model (which can be viewed as the `intertemporal' part of the cash-in-advance-constraint model)
• first we studied the determination of the price level when money supply is constant
  we found that:
  • the price level is given by the present discount of services provided by money...
  • ...but -differently from the case of durable goods- those services depend crucially on future price levels as well
  • we discussed the existence of an equilibrium for the price level, or equivalently, for real money balances - which depends among other things on the extent to which people can live without money ( $u_m \rightarrow \infty$ for $m \rightarrow 0$ was one of the conditions that guaranteed us existence)
• we studied the determination of inflation, nominal interest rate, and real interest rate
  we found that:
• the price level depends only on the path of money supply, on current and future income, and on future prices
• the nominal interest rate can be pinned down from the portfolio choice between money and bonds (both are financial activities)
• that same relationship determines the existence of a positive link between the demand for real money balances and income (if the services from holding money and consumption are complements) and of a negative link between the demand for real money balances and nominal interest rates
  in other words, we obtained the LM curve:
  $\frac{M^s}{p}=L(y,R)$
• a sort of Ricardian equivalence holds: given the path of money supply, the choice of the government between issuing debt and collecting taxes is irrelevant for the equilibrium inflation, nominal and real interest rates
• we focused on the equilibrium where the growth in money supply, and income, are constant
  we showed that:
  • the rate of inflation is equal to the rate of growth in real money balances
  • the real interest rate is constant
  • the nominal interest rate satisfies Fisher's relationship:
    $(1+R)=(1+r)(1+\mu)$
    and therefore increases when money growth (and inflation) increase
  • real money balances are constant, are a positive function of income, and are a negative function of money growth (not surprisingly from LM!)
  • we gave some conditions under which equilibrium real money balances (and therefore LM) exist
• our model suggests, and empirical evidence confirms, that the beginning of hyperinflation has something to do with the government printing money at a very fast pace
• we studied Friedman's rule: decrease the rate of growth of money until the nominal interest rate is zero (so to maximize real money holdings)
• we quantified the benefits from reducing inflation
• discussed reasons why Friedman's rule may not be applied: distortive taxation (Ramsey argument), and costs of disinflation
• we discussed unexpected changes in regime
  • in particular, how hyperinflations can be stopped immediately if the government credibly commits to stop money from growing forever after (forward looking nature of prices, which depend on future, and not past, inflation)
  • how the price level may actually decline because of the change in regime (due to the increase in real money balances)
  • and that for this reason governments may increase liquidity, before stopping money growth forever
  • the model describes somewhat well a number of historical episodes regarding the end of hyperinflations
• we discussed expected changes in regime
  • in particular, how inflation can be controlled by the mere announcement of future changes in the monetary policy regime.
  • at the time of the announcement, real money balances jump upward (like stock prices), and prices jump down.
  • again, this is due to the forward looking nature of prices.
  • this phenomenon actually occurred in episodes regarding the end of hyperinflations
• we discussed the link between monetary and fiscal policy
  • intertemporal budget constraint of the government
  • no Ponzi game condition
  • active/passive monetary/fiscal policies
  • a monetary policy reform imposes constraints on fiscal policy, and viceversa
  • inflation is not always a monetary phenomenon
• we discussed a case of passive monetary policy, active fiscal policy
  • stopping money supply from growing does not lead to a halt in inflation ...
  • ... if fiscal policy does not follow