Ebook Monetary Policy with Heterogenous Agents and Borrowing Constraints
One of the best-known propositions in textbook monetary economics is that concerning the long run neutrality of money, first shown by Sidrauski (1967). Yet there is growing empirical evidence that long-run changes in the level of inflation do in fact have real effects. A small increase in the rate of money growth in economies with initially low inflation rates is found to increase the long-run levels of capital stock (Kahn et al., 2006, Loayza, et al., 2000) and output (Bullard and Keating, 1995). In order to reconcile this apparent gap between traditional monetary theory and empirical evidence, a number of papers have re-evaluated the hypotheses under which long run inflation neutrality holds. Potential long-run real effects of monetary policy have been considered via inflation’s redistribution of seigniorage rents across households (Grandmont and Younès, 1973; and Kehoe et al., 1992) or across generations (Weiss, 1980; Weil, 1991), and inflation’s distortionary effect on capital taxation (Phelps, 1973 and Chari et al., 1996 among others) or labor supply (Den Haan, 1990).
This paper proposes a new channel for the non-neutrality of money transiting via borrowing constraints. If households can use both fiat money and capital to partially self-insure against individual income shocks, they may substitute away from real balances towards financial assets when inflation rises and the return to money falls. However, if there are asset market imperfections, borrowing-constrained households will not be able to undertake such portfolio adjustment and will adjust their money holdings differently compared to unconstrained households. Inflation thus triggers endogenous intra-period heterogeneity in money holdings when borrowing constraints are binding, providing incentives for unconstrained households with positive income shocks to increase their savings in order to smooth consumption between periods. Hence inflation may affect aggregate capital and output in the long run. Since the tightness of borrowing constraints is a well-established empirical fact (Jappelli 1990, Budria Rodriguez et al., 2002), this new channel may well account for a sizeable quantitative impact of inflation on the real economy and household welfare.
To investigate this effect, we model capital market imperfections in a production economy in which ex-ante identical infinitely-lived agents face idiosyncratic income shocks. They can accumulate interest-bearing financial assets in the form of capital to partially insure against income risks, but they face borrowing constraints. In this framework we embed money in the utility function. Money is valued both for its liquidity and as a store of value which provides additional insurance against labor-market risks. In this set-up, individuals are completely identical ex-ante. Heterogeneity in money demand emerges endogenously due to borrowing constraints.
The first contribution of this paper is theoretical. In an economy with deterministic income shocks à la Woodford (1990), we show that inflation has a long-run effect as long as borrowing constraints are binding. This occurs even in the absence of the other potential real effect channels which have been proposed in the existing literature, such as capital tax distortions, labor supply distortions, or distortionary redistribution of the seigniorage rent.
Second, we quantitatively evaluate the impact of borrowing constraints in explaining the potential long-run real effect of inflation. We do this by embedding Sidrauski’s money in the utility model into a fully-fledged incomplete market set-up à la Aiyagari (1994), in which heterogeneous agents face idiosyncratic income risks and borrowing constraints. One key element of this quantitative analysis is that we consider a wealth distribution, and in particular a fraction of borrowing-constrained households, which closely resembles that in the United States. We first gauge the specific quantitative role played by borrowing constraints and incomplete markets by eliminating all of the other potential frictions. Next, we quantify the potential interactions between incomplete markets and borrowing constraints, on the one hand, and the distortions put forward in the existing literature on the other. Specifically, we disentangle the quantitative real effects of inflation transiting through i) the non-neutral redistribution of the seigniorage rent across households, ii) the distorting effect on the capital tax, and eventually iii) the distorting effect on labor supply. We evaluate the contribution of incomplete markets with borrowing constraints to these real effects by comparing the outcomes to those from corresponding complete market economies.
Download
PDF Ebook Monetary Policy with Heterogenous Agents and Borrowing Constraints
Posted in :
