Ebook Money and Growth in a Production Economy with Multiple Assets
This paper deals with the question of how monetary policy affects growth. The traditional literature on monetary growth theory emphasizes the Mundell–Tobin or “portfolio” effect which says that money growth affects the capital stock positively, since higher inflation reduces the return on real balances which induces investors to reallocate savings from money to capital (see Mundell (1965), Tobin (1965)). Within dynamic general equilibrium models, however, such an effect is hard to find and most studies report either superneutrality of money or even a negative relation between money growth and real activity. As the theoretical literature, also empirical studies on this issue draw different conclusions.
Most of the theoretical literature considers only a single outside asset (money) and examines the effects of variations of the growth rate of this asset. In such a framework, however, the impact of different monetary strategies on real activity cannot be studied adequately. To address this issue, Schreft and Smith (1997, 1998) consider a Diamond–type overlapping generations model with outside money and government bonds in which different monetary policy strategies like a constant money growth rule, an inflation targeting or an interest targeting rule can be considered. They show that there exist multiple steady states and that the effects of monetary policy on the output level in these steady states are ambiguous.
Schreft and Smith assume that government bonds and physical capital are perfect substitutes in the portfolios of consumers and that firms finance their capital investments by loans for which they pay the same interest rate as the government on treasury bills. Thus, the rates of return on government bonds and capital coincide, and monetary policy has to affect both interest rates in the same way. For instance, if a higher bond return is induced by a tightening of monetary policy, the capital return and thereby capital investment increase as well. However, this assumption of Diamond–type growth models neglects that firms finance (part of) their capital investment by equities and that the equity return exceeds the return on government bonds. If there is a positive spread between the equity and the bond return, a higher bond return need not increase the capital return, but may decrease the risk premium, induce investors to buy less equities, and thereby induce firms to accumulate less capital. Hence, the traditional Mundell–Tobin effect reappears.
This paper departs from the model of Schreft and Smith in two important ways. First, firms finance capital investments by equities instead of bonds and the equity return exceeds the bond return, since there are stochastic productivity shocks and since consumers are risk averse. Second, because of an Arrow–Romer spillover of capital investment on labor productivity, the aggregate technology exhibits increasing returns to scale which gives rise to endogenous growth. This enables us to study the growth effects of monetary policy.
Specifically, consumers have to transfer the labor income of their first lifetime period to the second period by means of three assets: money, government bonds, and equities. Because of a cash–in–advance constraint consumers hold money even if it is return dominated by bonds and equities. Since consumers are risk averse and since the equity return is uncertain, both the equity and the bond demand can be positive when there is a positive (expected) equity premium. Firms finance capital investments only by issuing equities. The government consumes a fixed share of output and finances its deficit by bonds and by seignorage, whereas the monetary authority controls the money supply by conducting open market operations. Hence, the monetary authority determines the seignorage revenue of the government and can apply different types of monetary strategies. We consider four different monetary policy strategies: a constant money growth rule, a stabilization of the ratio of money to bonds, an inflation targeting and an interest rate targeting rule.
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