lOMoAR cPSD| 45211451
CHAP 4 Modeling Monetary Economies
4th Edition
MONEY AND BANKING
, lOMoAR cPSD| 45211451
Chapter 4
Inflation
1 Roadmap
So far, we have shown that money is memory, it
reduces transaction costs compared with barter and frees up
resources compared with a commodity money economy. In Chapter
1
, we focused on the demand for money. The next step
is consider how changes in money supply affect economic
decisions.
In this chapter, we learn that increasing the stock of fiat
money represents a form of revenue for the government.
Seigniorage is the name given to value of resources collected by
the governmentfrom money creation. Revenues collected by the
government also represent taxes paid by people; from taxpayer’s
1
Inflation
We have seen that we can find a role for money with
either the simple, single-good model of Chapter 2 or
the more complex multiple-good model of Chapter 3.1
It can be verified that both models have essentially the
same implications for the subject of this chapter, inflation,
and for the subjects of later chapters. If two models
have the same implications for a topic of interest, then it
is generally preferable to work with the simpler model. For
this reason, we use the single-good model of Chapter
2 as the framework for this and following chapters.
There is a very simple, compelling reason to examine
the effects which changes in the fiat money supply have
on economic decisions. Figure 4.1 plots the quantity of
base
, lOMoAR cPSD| 45211451
perspective, the revenues are known as the inflation tax.
Therefore, we have to specify how the government spends this
revenue. In other words, just like people face a lifetime
budget constraint, there is a governmentbudget constraint. Our
focus is to analyze the effect whichthis governmentpolicy has on
people’s welfare. In addition, we examine the revenue
implications associated with different money growth rates.
money – the sum of currency in the hands of the
nonbank publicand total reserves – over the period 1985
through 2015. We use base money as the measure of the
fiat money supply in our model economy. Base money is
issued by the government. Certainly, there has been a dramatic
increase in the quantity of base money since 2008. Even if
you could look over the period from 1985 through 2007, you
would see that the quantity of base money changed over
time. This observation alone is sufficient to motivate our analysis of
the effects that such changes have on economic decisions.
Figure 4.1. Money supply changes over time. This is a
plot of the quantity of base money over the period 1985
, lOMoAR cPSD| 45211451
through 2015. Recessions are identified by gray shaded bars.
By this measure, the quantity of fiat money is not
constant over time.
We begin in a very simplified version of the model
economy in which money is the only store of value. In this
way, we can see how changes in the money growth rate
affects consumption when young versus consumption
when old, welfare, and the demand for money.
3 A Growing Supply of Fiat Money
Let us now study the effects of an expansion of the
supply of fiat money. First we consider money supply
expansion in the simplest overlapping generations model with a
constant population and a nonstorable consumption good. Contrary
to what we saw in Chapter 2, no commodity money is
present in the economy.
Let the money supply growth be such that
(4.1)
for each period where , the gross rate of money
supply expansion, is greater than 1. This implies that
(4.2)
units of new fiat money are printed each period. This new
money is introduced into the economy by means of
lump-sum subsidies (transfers) to each old people in every
period worth units of the consumption good; that is,
CHAP 4 Modeling Monetary Economies
4th Edition
MONEY AND BANKING
, lOMoAR cPSD| 45211451
Chapter 4
Inflation
1 Roadmap
So far, we have shown that money is memory, it
reduces transaction costs compared with barter and frees up
resources compared with a commodity money economy. In Chapter
1
, we focused on the demand for money. The next step
is consider how changes in money supply affect economic
decisions.
In this chapter, we learn that increasing the stock of fiat
money represents a form of revenue for the government.
Seigniorage is the name given to value of resources collected by
the governmentfrom money creation. Revenues collected by the
government also represent taxes paid by people; from taxpayer’s
1
Inflation
We have seen that we can find a role for money with
either the simple, single-good model of Chapter 2 or
the more complex multiple-good model of Chapter 3.1
It can be verified that both models have essentially the
same implications for the subject of this chapter, inflation,
and for the subjects of later chapters. If two models
have the same implications for a topic of interest, then it
is generally preferable to work with the simpler model. For
this reason, we use the single-good model of Chapter
2 as the framework for this and following chapters.
There is a very simple, compelling reason to examine
the effects which changes in the fiat money supply have
on economic decisions. Figure 4.1 plots the quantity of
base
, lOMoAR cPSD| 45211451
perspective, the revenues are known as the inflation tax.
Therefore, we have to specify how the government spends this
revenue. In other words, just like people face a lifetime
budget constraint, there is a governmentbudget constraint. Our
focus is to analyze the effect whichthis governmentpolicy has on
people’s welfare. In addition, we examine the revenue
implications associated with different money growth rates.
money – the sum of currency in the hands of the
nonbank publicand total reserves – over the period 1985
through 2015. We use base money as the measure of the
fiat money supply in our model economy. Base money is
issued by the government. Certainly, there has been a dramatic
increase in the quantity of base money since 2008. Even if
you could look over the period from 1985 through 2007, you
would see that the quantity of base money changed over
time. This observation alone is sufficient to motivate our analysis of
the effects that such changes have on economic decisions.
Figure 4.1. Money supply changes over time. This is a
plot of the quantity of base money over the period 1985
, lOMoAR cPSD| 45211451
through 2015. Recessions are identified by gray shaded bars.
By this measure, the quantity of fiat money is not
constant over time.
We begin in a very simplified version of the model
economy in which money is the only store of value. In this
way, we can see how changes in the money growth rate
affects consumption when young versus consumption
when old, welfare, and the demand for money.
3 A Growing Supply of Fiat Money
Let us now study the effects of an expansion of the
supply of fiat money. First we consider money supply
expansion in the simplest overlapping generations model with a
constant population and a nonstorable consumption good. Contrary
to what we saw in Chapter 2, no commodity money is
present in the economy.
Let the money supply growth be such that
(4.1)
for each period where , the gross rate of money
supply expansion, is greater than 1. This implies that
(4.2)
units of new fiat money are printed each period. This new
money is introduced into the economy by means of
lump-sum subsidies (transfers) to each old people in every
period worth units of the consumption good; that is,
