Monetary Economics II: Theory and Policy ECON 3440C: Tasso Adamopoulos York University
Monetary Economics II: Theory and Policy ECON 3440C: Tasso Adamopoulos York University
Monetary Economics II: Theory and Policy ECON 3440C: Tasso Adamopoulos York University
ECON 3440C
Tasso Adamopoulos
York University
Fall 2021
Lecture 9
We used the OLG model to model exchange, without taking the age
structure seriously.
Now we will take the age structure of the OLG model seriously and
turn to the subject of the determinants of aggregate
savings/investment.
c1,t + st ≤ y1
c2,t+1 ≤ y2 + r · st
ENDOWMENT POINT
Yz
1
y Y 4
This gives optimal consumption in the two periods of life as (c1∗ , c2∗ ).
Then from the first period budget constraint we can solve for optimal
savings as,
s ∗ = y1 − c1∗
Savings can be negative, which would mean that you are borrowing
against your future income.
iif
ya f
1
c
Yi 4,1 42
r G
s I Y Cf
Wealth
Note, wealth is not simply the sum of incomes in the two periods
y1 + y2 , but y2 is expressed in present value terms (divided by r ).
x x r CFV or TV
Ir y Pv
FV
pre D FV r PV
f
PV lifetime income
we y
tYz
with 3 periods
wt yet
42ft YI
r2
Wealth and Consumption
For a given w , the (c1 , c2 ) chosen does not depend on when that
wealth is received → a given w is consistent with many different
combinations of (y1 , y2 ) for given r .
In all these different cases only w matters not the allocation across y1
and y2 → same lifetime budget constraint.
c1,t + st ≤ y1 − τ1
c2,t+1 ≤ y2 + r · st − τ2
Yz z I
Y 7 Yi 2 t 4
Cf we
9
S
Wealth Neutral Tax Changes
Consider changes in taxes (τ1 , τ2 ) that do not affect an individual
taxpayer’s wealth.
Message: here the PV of lifetime taxes matters only but not the
timing of those taxes.
Now the lifetime tax burden increases → taxpayer lifetime wealth falls
→ drop in lifetime consumption → drop in both c1 and c2 since both
normal goods.
In the real world many other assets can serve this role.
Start with the simplest OLG model with capital, denoted kt per
young person.
Each initial old begins with a stock of capital k0 , that produces xk0
goods in the first period.
c1,t + kt ≤ y
c2,t+1 ≤ xkt
L y c
savings in the
Form of capital
Diminishing Returns Production
In this simple model it was assumed that output from each unit of
capital is the same regardless of how much capital already exists
→ the rate of return to capital is a fixed number x, unaffected by
economic forces.
∆f (k)
MPK = = f 0 (k) > 0
∆k
→ upward sloping production function.
When markets are competitive then MPK = f 0 (k) is also the real rate
of return to capital.
LY
Total Prodeet
Constant Returns
fcq x
o h
Total Product
f Kk x
x risk
h
Marginal Product
3. Rate of Return Equality
People can store value over time (save) in many other ways.
I e.g., purchase land and sell it when they want to consume; make loans
to people who want to borrow against future income (private debt).
For people to be willing to hold both capital and loans as assets, their
rates of return must be identical,
r =x
More generally, when there are many assets available to the individual, and
there is no uncertainty about returns and no government restrictions
interfering with the individuals’ holdings of those assets, it must be that
their returns are identical if individuals are to hold them all simultaneously.
People who want to save view capital, loans and money as perfect
substitutes.
Example: suppose that there is only capital and fiat money, and that
n = 1.5 and x = 1.25. When will fiat money be valued?
n 1.5 1.5
I Answer: if z ≥x ⇒ z ≥ 1.25 ⇒ z ≤ 1.25 = 1.2.
There are two assets: capital (k) and fiat money (m).
When fiat money and capital are both valued the desired capital stock
k is determined by real rate of return equality condition.
In the figure, when the real rate of return to fiat money is n/z the
desired capital holdings k ∗ are where the MPK curve (downward
sloping in k) intersects the n/z line.
People stop switching from fiat money to capital either when fiat
money balances have fallen to zero (m → 0) or when the rate of
return on capital falls to the new lower rate of return to fiat money,
0 n n
f 0 k∗ = 0 <
z z
0
→ k ∗ > k ∗.
Given that capital generates output next period, the larger the capital
stock, the larger the subsequent increase in output.