Money in Utility

Walsh, Ch.2
• Need to introduce money in RBC model, to answer:

– If the real shock explains significant part of business cycle,

then how about monetary shock?

– What is the optimal monetary policy?

∗ By the way, do a policy authority need to stabilize the

fluctuation of the economy caused by TFP?
• Among the four functions of money, the one that belongs
only to the money is a medium of exchange or transaction.

• In this vein, cash in advance (CIA) model or shopping time

model are developed.

– CIA constraint (Clower 1967)

Ptct ≤ Mt

– Shopping time constraint (Tobin’s shoe lather cost)

!
Mt
l t + s ct , =1
Pt

• After all, both of them means that money gives any util-
ity to HH. Hence, just include money in the utility (MIU)
function!(Sidrauski 1967)
The Model

• Social planner’s problem

– We can set the economy’s problem as social planner’s

problem when there is no artificial distortion in the econ-
omy.

V (at , kt−1 ) = max u(ct , mt , 1 − nt ) + βEt V (at+1 , kt )

ct ,mt ,bt ,kt ,nt

s.t

f (kt−1 , nt , zt ) + (1 − δ)kt−1 + at ≥ ct + kt + bt + mt

where

1 + it mt
at+1 = τt + bt + .
1 + πt+1 1 + πt+1
Then, from foc and ENV (note that V is a function of two
state variables),

ul (t) = uc(t)fn(kt−1, nt, zt)

which determines labor choice in terms of consumption. When

HH increases the leisure, the increased marginal utility of
leisure should be the same with the decreased marginal util-
ity of consumption.
 " #
1 + it
uc(t) = βEt uc(t + 1)
1 + πt+1

which is a Euler equation. The marginal utility of decreased

current consumption should be the same with marginal utility
of increased future consumption.
 " #
uc(t + 1)
um(t) + βEt = uc(t)
1 + πt+1

which determines the demand of money. This states that

the marginal benefit of adding to money holdings must equal
the decreased marginal utility of consumption.

The benefit of holding money has two components. One

from utility function, the other is a value as an asset for the
future consumption.
– From the above two equations, we can derive

um(t) it
= .
uc(t) 1 + it

it
Note that is the opportunity cost of holding money,
1 + it
or private cost of holding money.
Q: What is the marginal cost of producing money?

– There is a wedge between social cost and individual cost

of holding additional money, which causes inefficiency of
the economy.

To remove this wedge, monetary policy authority should

make it to be zero, or πt+1 = −rt: Friedman Rule for
optimal inflation rate!

– If we introduce the government to the model economy,

it
then it can be shown that is the inflation tax rate
1 + it
which distorts the efficiency of the economy.
• In addition to these three equations, following equations con-
stitute equilibrium system:

resource constraint

kt = (1 − δ)kt−1 + yt − ct

production function

yt = f (kt−1, nt, zt)

real money balance identification

1 + θt
mt = mt−1
1 + πt

which is derived from Mt = (1 + θt)Mt−1,

Fisher equation

(1 + rt)(1 + πt+1) = 1 + it
technology shock process

zt = ρz zt−1 + et

monetary policy shock process

νt = ρν νt−1 + φzt−1 + ϕt

where νt ≡ θt − θ̄ and et and ϕt are white noise.

• Now, specific forms of utility and production functions are
given as

1−b 1−b 1−Φ

[act + (1 − a)mt )] 1−b (1 − nt)1−η
u(t) = +Ψ
1−Φ 1−η

α n1−α
yt = ezt kt−1 t

we can compute steady state. As in RBC model, if you get

n̄ wrt parameters, then the rest of the steady state values of
endogenous variables are determined.
– n̄ is obtained by solving

 b−Φ
 b−1

− 1  1−b
n̄Φ a Θ−β

b b
= H 1 + 
(1 − n̄)η 1−a Θ

where

  − α  −Φ !−Φ
1−α ȳ 1−α 1−Φ c̄ k̄

H= a 1−b
Ψ k̄ k̄ n̄

and Θ = 1 + θ̄.

– Here note that inflation rate Θ affects steady state level

of real variable by affecting labor choice.
• Now, log linearizing, for endogenous variables of yt, ct, kt, nt,
λt, it, rt, mt, πt, zt, νt

yt = αkt−1 + (1 − α)nt + zt
ȳ c̄
yt = ct + kt − (1 − δ)kt−1
k̄ k̄
ȳ
rt = α (yt+1 − kt )
k̄
λt = −[γΦ + (1 − γ)b]ct + (b − Φ)(1 − γ)mt
λ = rt + λt+1
   t
n̄
1+η nt = yt + λt
l̄
it = rt + πt+1
1
mt = ct − it
b
mt = mt−1 − πt + νt
zt = ρz zt−1 + et
νt = ρν νt−1 + φzt−1 + ϕt

ac̄1−b 1−b
where γ = ac̄1−b +(1−a)m̄
.
• Solving this equilibrium system and simulating with the change
of φ, we can see that monetary policy effects are negligible.

• To make the short term monetary policy to have effects on

the economy, we study new Keynesian DSGE model.