The implications of a wealth preference in a monetary equilibrium model of the business cycle /

No Thumbnail Available
Morris, Pamela
Journal Title
Journal ISSN
Volume Title
Middle Tennessee State University
The "Implications of a Wealth Preference in a Monetary Equilibrium Model of the Business Cycle" is composed of two papers: "The Economic Impact of a Preference for Wealth" and "The Welfare Costs of Inflation When Agents Have a Relative Preference for Wealth." In both of the papers a relative preference for wealth is added to the households' utility function.1.
The first paper incorporates a demand for money through the use of a cash-in-advance constraint. The cash-in-advance constraint is designed to look at an economy that demands cash for the purchase of consumption goods only as well as an economy that demands cash for the purchase of consumption and investment goods. Households' response to a money growth rate innovation is qualitatively different under these two money demand rules. The addition of a preference for wealth causes a persistent response even when the money is demanded only for consumption goods. Increasing the relative preference for wealth dampens the quantitative response of output but does not affect its qualitative features.
The dynamic response of wages and rental rates to a money growth rate innovation inspired an investigation into the long-run properties of the model. When money is demanded for consumption goods, inflation has no effect on the long-run real marginal cost of labor or rental rates. However, when a relative preference for wealth exists, an inflationary effect on these variables presents itself. In the case where money is demanded for consumption and investment, superneutrality does not hold regardless of the wealth preferences. However, the capital-to-hours ratio determining the real wage and real returns to capital declines as inflation increases and increases with the preference for wealth. This translates to a reduction in the real wage and an increase in the real return to capital as the level of inflation increases regardless of the preference for wealth.
The first paper points to differences in the economic impacts that are due to wealth preferences and to the important role that money demand plays in the economy's response to inflation. When money is used for consumption purposes only, the velocity of money is set to unity. However, when money is used for both consumption and investment, the velocity of money is no longer equal to one. The vast differences in the responses associated with differences in money demand naturally led to the welfare cost investigation of Paper 2, in which the velocity of money plays a larger role.
The second paper incorporates a transaction cost mechanism that is dependent on the velocity of money. At the Pareto optimal velocity, no transaction costs are present. However, as the velocity of money moves further away from the optimal level, households realize a cost in terms of lost consumption. The households' demand for money adjusts as interest rates affect the velocity of money. Thus, the welfare costs of inflation are determined under two different policy approaches.
Policymakers are first assumed to target only money growth rates. The second policy approach analyzed assumes that policymakers target interest rates in order to maintain price stability and a sustainable output growth. This second assumption is more in line with the stated goals of monetary policymakers in the U.S. The welfare costs are determined for various levels of inflation and various wealth preferences under a utility function in which households' have separable preferences over consumption and wealth and two non-separable cases in which consumption and wealth are complements and substitutes. 2.
When policymakers target money growth rates only, welfare costs of inflation are small at moderate rates of inflation between 0 and 4.25 percent. In the separable case the welfare costs of inflation decrease with the preference for wealth. The welfare costs of inflation are not as affected by wealth preferences under the non-separable cases, though slightly larger differences are present when consumption and wealth are assumed to be substitutes.
When the policymakers target interest rates, setting the velocity of money, interesting results are found. Welfare costs in terms of goods are associated with money growth rates greater than 2 to 3 percent, and welfare gains in terms of goods are present at money growth rates 2 percent or less. The money growth rate at which the welfare costs are zero rises as the preference for wealth increases. This result is similar under the separable and non-separable cases, although the separable case is much more sensitive to wealth preference changes. (Abstract shortened by UMI.).
1The weights placed on consumption and wealth sum to unity. 2The model incorporates the indivisible labor assumption of Hansen (1985), providing a channel through which inflationary impacts on employment enter the model.
Adviser: Gregory E. Givens.