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  • 1. Monetary Economics 2004 Max Gillman Central European University Winter Semester, February 24 - March 26 1 Introduction Monetary economics concerns the nominal side of the economy as opposed to only the real side, to use the old Walrasian classical dichotomy. General equilibrium conditions based on optimization techniques that derive both nominal and real variables no longer rely on such a distinction, but they are sensitive to how money is introduced into the economy. The introduction of money in partial equilibrium analysis is simpler: money demand functions for example can be specified directly, and can be empirically studied directly. In general equilibrium, these money demand function are part of the set of equilibrium conditions that are derived. The nature of these money demand functions, and how they relate to partial equilibrium specifications, depends on the nature of the way in which money is introduced in the general equilibrium. There are several commonly used models of money in general equilibrium. And here what is meant by general equilibrium really means dynamic general models. In a sort of chronological order, there is the overlapping generations model of money due originally to Samuelson, the money-in-the-utility-function model of Sidrauski (1967), the cash-in- advance model of Lucas (1980), and the shopping time model of McCallum (1983). And there are the non-optimization policy models in widespread use. The use of the general equilibrium models of money is diverse, as diverse as all on macroeconomics. International macroeconomics involving exchange rates can be built upon open-economy general equilibrium monetary economics, although often it is not, using only relative aggregate price levels as the definition of real exchange rates. Or the "small open economy" assumption of given real interest rates can be made, again with or without monetary models. The closed-economy general equilibrium models with money are used to study both growth and business cycles. 1
  • 2. Applications of the models are quite dependent upon the nature of the particular general equilibrium model of money that is being used. And special ad hoc assumptions are added to the models at times in order to produce results that conform more closely to the related evidence. Of course these ad hoc assumptions can be viewed as an intermediate step towards producing a more general equilibrium model that likewise conforms with the evidence. This is how evidence plays an important role in model building in monetary economics, as in all fields. The ultimate use of models that appear to provide a good description of the economy is their application to study policy issues. As policy constantly demands the attention of the profession, policy models often are based in partial equilibrium, ad hoc, methods because the issues are ahead of the capability of the general equilibrium capability to provide a full analysis. This makes the study of policy, while in many senses the most important subject, the most difficult to do rigorously with the latest development in the general equilibrium modelling. As such policy analysis often demands a compromise of methods. At the same time, minimizing this compromise drives development of the general equilibrium theory. Empirics, model building, and policy analysis intermix in creating the discipline of monetary economics. All three tend to be required to be current for the presentation of any one analysis, although the mix varies dramatically. The course will present aspects of these three elements. 2 Empirical Evidence 2.1 Money and Inflation 2.1.1 Money To Prices Money demand, fixed exchange rate systems. Cagan (1956), Fischer, Sahay, and Végh (2002), McCallum (1987), Chapter 15 “Episodes in US Monetary History”, Rolnick and Weber (1997). 2.1.2 VARS Walsh (2003) Chapter 1, Cochrane (1998), Cochrane and Piszzesi (2002), Kraft (2003), Ross (1998), Bernanke, Boivin, and Eliasz (2004) 2
  • 3. 2.1.3 Unit Roots and Granger Causality Crowder (1998), Crowder, Hoffman, and Rasche (1999), Crowder and Wohar (????), Per- ron (1989), Culver and Papell (1997), Benati and Kapetanios (2002), Caporale and Gil- Ilana (2003) 2.1.4 Money Demand Cagan (1956), Marcet and Nicolini (2003), Mark and Sul (2002). 2.2 Money, Output, Banking, and Tobin Banking shocks, Depressions, VARs, anticipated effects, Tobin, TFP shocks. Friedman and Schwartz (1963), Ghosh and Ghosh (1999), Calomiris and Mason (2003b), Calomiris and Mason (2003a), Kehoe and Prescott (2001), Hopenhayn and Neumeyer (2002), Ahmed and Rogers (2000), Gillman and Nakov (2003a), Rapach (2003), Rapach and Wohar (2004), Uhlig (2003), Chari, Kehoe, and McGrattan (2003). 2.3 Money and Growth Judson and Orphanides (1996), Ghosh and Phillips (1998), Gylfason and Herbertsson (2001), Barro (2001), Khan and Senhadji (2001) and Gillman, Harris, and Matyas (2004), Gillman and Nakov (2002), Gillman and Wallace (2003). 2.4 Money and Unemployment Haldane and Quah (1999), Ireland (1999), Romer (2000), Ball and Mankiw (2002), Shadman-Mehta (2001), Ljungqvist and Sargent (2002). 2.5 Money and Commodity Prices Hamilton (1983), Perron (1989), Hooker (1999), Hooker (2002), Jones, Leiby, and Paik (2002). 2.6 Money and Asset Prices McGrattan and Prescott (2001), McGrattan and Prescott (2003), Gillman and Nakov (2003b). 3
  • 4. 3 Theory 3.0.1 Partial Equilibrium Cagan (1956), Baumol (1952), Tobin (1956). 3.0.2 Overlapping Generations Samuelson (1958), Lucas (1972), Wallace (1980), Lucas (1996). 3.0.3 Money in the Utility Function Samuelson (1948), Sidrauski (1967), Eckstein and Leiderman (1992), Lucas (2000), Walsh (2003) Chapter 2. 3.0.4 Cash-in-Advance Hicks (1935), Lucas (1980), Lucas (1988). 3.0.5 Cash-Credit Lucas and Stokey (1983), Lucas and Stokey (1987), Lucas (2000), Walsh (2003) Chapters 2 and 3, Ljungqvist and Sargent (2000) 17:493-500. 3.0.6 Shopping Time Lucas (2000), Walsh (2003), Chapter 3, Ljungqvist and Sargent (2000) 17:493-500. 3.1 The Welfare Cost of Inflation Gillman (1993), Gillman (1995), Dotsey and Ireland (1996), Marty (1999), Lucas (2000), Marty (1967). 3.2 Money, Inflation, Output, and Growth Sidrauski (1967), Tobin (1956), Tobin (1965), Stockman (1981), Temple (2000), Gomme (1993), Ireland (1994), Chari, Jones, and Manuelli (1996), Haslag (1998), Gillman and Kejak (2004a), Gillman and Kejak (2005), Parente, Rogerson, and Wright (1999), Parente, Rogerson, and Wright (2000). 4
  • 5. 3.3 Financial Development and the Theory of Credit King and Levine (1993), Levine (1997), Levine, Loayza, and Beck (2000), Boyd and Smith (2001), Rousseau and Wachtel (2001), Gillman and Harris (2003), Dawson (2003), Gillman and Harris (2003), Gillman and Harris (2004), Kocherlakota (2000). 3.4 The Credit Channel Warner and Georges (2001), Walsh (2003)7: 323-362, Bohacek and Medizabal (2004). 3.5 Money Demand and Velocity Jovanovic (1982), Eckstein and Leiderman (1992), Bental and Eckstein (1997), Gillman (1993), Ireland (1995), Chari, Christiano, and Eichenbaum (1995), Gillman, Siklos, and Silver (1997), Bental and Eckstein (1997), Gillman and Otto (2002), Gillman and Kejak (2004b), Szapary (2001), Gillman and Nakov (2002). 3.6 Theory of the Aggregate Price Level Gillman (2002), McCallum (2001a), Walsh (2003)4:164-171 and 10: 474-480, Canzoneri and Diba (2003), ?, Ljungqvist and Sargent (2000): 506-507, Schabert (2004), Cochrane (2003b), Cochrane (2003a). 3.7 Monetary Business Cycles Rose (1969), Cooley (1995), Cooley and Hansen (1998), Gavin and Kydland (1999), Berger, Kyle, and Scalise (2003), Tallman and Bharucha (2000), Benk, Gillman, and Kejak (2004). 3.8 Liquidity Effect Li (2000), Einarsson and Marquis (2000). 3.9 Money and the Open Economy Calvo and Mishkin (2003), Walsh (2003)Chapter 6. 5
  • 6. 4 Policy Tsiang (1969), Svensson (2003), McCallum (2000), McCallum (2001b), Walsh (2003)4: 135-172, Chapters 5, 8, 9, 10: 499-514, 11. 4.1 Second-Best Ramsey Theory of Optimal Inflation Braun (1994), Gillman (2000), Lucas (2000), Ljungqvist and Sargent (2000): 510-514, Walsh (2003)4: 172-191, Gillman and Yerokhin (2003), Burnell and Kim (2003), Alvarez, Kehoe, and Neumeyer (2002). 4.2 Rules versus Discretion Bernanke and Mishkin (1997), Alvarez, Lucas, and Weber (2001), Schabert and Bruckner (2002), Schabert (2003), Schabert (2004), Chowdhury and Schabert (2003), Linnemann and Schabert (2003), Siklos and Abel (2001). A Homework and Exam A.1 Weekly Sets: 20% HW1: Any 5 of the questions in Walsh (2003) 2: 1-11, due March 2; HW2: Any 4 of the questions in Walsh (2003) 3: 1-9, due March 9; HW3: Walsh (2003) 4: 1, 2, 5, 7, due March 17. A.2 End of Course Project: 30% Choose one of the following three projects, due March 26: 1. Estimate a VAR with structural break testing for Money, Prices, and Income as in Gillman and Nakov (2002), for a transition/accesion country that is pre-approved by the lecturer. 2. Estimate the degree to which actual nominal interest rates followed the interest rates that would have resulted if the country had followed a Taylor rule of monetary policy, for a transition/accession country pre-approved by the lecturer. 3. Go through and derive all the equations in a journal article or working paper that is found in the Reference list below and that is pre-approved by the lecturer. 6
  • 7. A.3 Final Exam: 50% The exam will be based on the lectures. Regular class attendance is recommended. A.4 On Reserve Monetary economics : theory and policy / Bennett T. McCallum McCallum, Bennett T. Required Readings /RH — 332.4 MCC — AVAILABLE Monetary theory and policy / Carl E. Walsh Walsh, Carl E. Required Readings /RH — 332.4/6 WAL — AVAILABLE Recursive macroeconomic theory / Lars Ljungqvist, T.J. Sargent Ljungqvist, Lars Required Readings /RH — 339./015 LJU — AVAILABLE Recursive macroeconomic theory / Lars Ljungqvist, T. J. Sargent Ljungqvist, Lars Required Readings /RH — 339./015 LJU — AVAILABLE Recursive macroeconomic theory / Lars Ljungqvist, T. J. Sargent Ljungqvist, Lars Required Readings /RH — 339./015 LJU — AVAILABLE Recursive macroeconomic theory / Lars Ljungqvist, T. J. Sargent Ljungqvist, Lars Required Readings /RH — 339./015 LJU — AVAILABLE Recursive macroeconomic theory / Lars Ljungqvist, T. J. Sargent Ljungqvist, Lars Required Readings /RH — 339./015 LJU — AVAILABLE Studies in the quantity theory of money / edited by Milton Friedmann ; with essays by Milton Friedman. Required Readings /RH — 332.4/01 FRI — AVAILABLE References Ahmed, S., and J. H. Rogers (2000): “Inflation and the Great Ratios: Long Term Evidence from the US,” Journal of Monetary Economics, 45(1), 3—36. Alvarez, A., R. E. Lucas, and W. E. Weber (2001): “Interest Rates and Inflation,” American Economic Review, 91(2), 219—225. Alvarez, F., P. Kehoe, and P. Neumeyer (2002): “The Time Consistency of Mon- etary and Fiscal Policies,” Federal Reserve Bank of Minneapolis Research Department Working Paper 616, (616). 7
  • 8. Ball, L., and G. Mankiw (2002): “The NAIRU in Theory and Practice,” Journal of Economic Perspectives, 16(4), 115—136. Barro, R. (2001): “Human Capital and Growth,” American Economic Review, pp. 1—7. Baumol, W. (1952): “The Transactions Demand for Cash: An Inventory -Theoretic Approach,” Quarterly Journal of Economics, 66, 545—66. Benati, L., and G. Kapetanios (2002): “Structural Breaks in Inflation Dynamics,” Bank of England manuscript. Benk, S., M. Gillman, and M. Kejak (2004): “Credit Shocks in a Monetary Business Cycle,” Manuscript, Central European University. Bental, B., and Z. Eckstein (1997): “On The Fit of a Neoclassical Monetary Model in High Inflation: Israel 1972-1990,” Journal of Money, Credit and Banking, 29(4, Part 2), 725—752. Berger, A., M. Kyle, and J. Scalise (2003): Prudential Supervision: What Works and What Doesntchap. Did US Bank Supervisors Get Tougher During the Credit Crunch, Easier During the Banking Boom, and Did It Matter to Bank Lending. Uni- versity of Chicago Press. Bernanke, B., J. Boivin, and P. Eliasz (2004): “Measuring the Effects of Mone- tary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach,” Federal Reserve Board Finance and Economics Discussion Series, (3). Bernanke, B., and F. Mishkin (1997): “Inflation Targeting: A New Framework for Monetary Policy,” Journal of Economic Perspectives, 11(2), 97—116. Bohacek, R., and H. Medizabal (2004): “Credit Markets and the Propigation of Monetary Policy Shocks,” Manuscript. Boyd, J.H., R. L., and B. Smith (2001): “The Impact of Inflation on Financial Sector Performance,” Journal of Monetary Economics, 47(2), 221—249. Braun, R. A. (1994): “How Large is the Optimal Inflation Tax?,” Journal of Monetary Economics, 34(2), 201—214. 8
  • 9. Burnell, S., and Y. Kim (2003): “Money, Tax Evasion and the Optimal Inflation Rate,” Paper presented at the 2003 North American Summer Meetings of the Econometic So- ciety. Cagan, P. (1956): “The Monetary Dynamics of Hyperinflation,” in Studies in the Quan- tity Theory of Money, ed. by M. Friedman, pp. 25—120. The University of Chicago Press, Chicago. Calomiris, C., and J. Mason (2003a): “Consequences of Bank Distress During the Great Depression,” Americal Economic Review, 93(3), 937—947. (2003b): “Fundamentals, Panics, and Bank Distress During the Depression,” Americal Economic Review, 93(5), 1615—1677. Calvo, G., and F. Mishkin (2003): “The Mirage of Exchange Rate Regimes for Emerg- ing Market Countries,” Journal of Economic Perspectives, 17(4), 99—118. Canzoneri, M., and B. Diba (2003): “Interest Rate Rules and Price Determinacy,” Manuscript. Caporale, G., and L. Gil-Ilana (2003): “Long Memory and Structural Breaks in Hyperinflation Countries,” Journal of Economics and Finance, 27(2), 136—52. Chari, V., L. Christiano, and M. Eichenbaum (1995): “Inside Money, Outside Money, and Short Term Interest Rates,” Journal of Money, Credit, and Banking, 27(4, Part 2), 1354—1386. Chari, V., L. E. Jones, and R. E. Manuelli (1996): “Inflation, Growth, and Finan- cial Intermediation,” Federal Reserve Bank of St. Louis Review, 78(3). Chari, V., P. Kehoe, and E. McGrattan (2003): “Business Cycle Accounting,” Federal Reserve Bank of Minneapolis Research Department Working Paper 625, (625). Chowdhury, I., and A. Schabert (2003): “Assessing Money Supply Rules,” Working Paper 2003/9, Department of Economics, University of Glasgow. Cochrane, J. (1998): “What Do the VARs Mean?: Measuring the Output Effects of Monetary Policy,” Journal of Monetary Economics, 41(2), 277—300. (2003a): “Fiscal Foundations of Monetary Regimes,” Manuscript, University of Chicago. 9
  • 10. (2003b): “Money as Stock,” Manuscript, University fo Chicago. Cochrane, J., and M. Piszzesi (2002): “The Fed and Interest Rates—A High-Frequency Identification,” American Economic Review, 92(2), 90—95, Conference Proceedings. Cooley, T. F. (ed.) (1995): Frontiers in The Business Cycle Research. Princeton University Press, Princeton, New Jersey, 1 edn. Cooley, T. F., and G. D. Hansen (1998): “The Role of Monetary Shocks in Equi- librium Business Cycle Theory: Three Examples,” European Economic Review, 42, 605—617. Crowder, W., D. Hoffman, and R. Rasche (1999): “Identification, Long-Run Re- lations, and Fundamental Innovations in a Simple Cointegrated System,” Review of Economics and Statistics, 81(1). Crowder, W., and M. Wohar (????): “A Cointegrated Structural VAR Model of the Canadian Economy,” Applied Economics ., Forthcoming. Crowder, W. J. (1998): “The Long-Run Link Between Money Growth and Inflation,” Economic Inquiry, 36(2), 229—43. Culver, S., and D. Papell (1997): “Is There a Unit Root in Inflation Rate? Evidence from Sequential Break and Panel Data Analysis,” Journal of Applied Econometrics, 12(4), 435—444. Dawson, P. J. (2003): “Financial Development and Growth in Economies in Transition,” Applied Economic Letters, 10, 833—836. Dotsey, M., and P. N. Ireland (1996): “Inflation in General Equilibrium,” Journal of Monetary Economics, 37(1), 29—47. Eckstein, Z., and L. Leiderman (1992): “Seigniorage and the welfare cost of infla- tion: Evidence from an intertemporal model of money and consumption,” Journal of Monetary Economics, 29(3), 389—410. Einarsson, T., and M. H. Marquis (2000): “Liquidity Effects and Financial Inter- mediation in a Model with a Frictionless Bond Market,” Federal Reserve Bank of San Francisco Working Paper 00-08. 10
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