Money, Credit, and Prices in a Real Business Cycle OR。 Robert g. King: Charles I. plosser The American Economic Review, Vol. 74, No. 3.(Jun, 1984), pp. 363-380 Stable url: http://inks.jstororg/sici?sici0002-8282%28198406%02974%03a3%3c363%3amcapia%3e2,0.c0%03b2-w The American Economic Review is currently published by American Economic Association Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.htmlJstOr'sTermsandConditionsofUseprovidesinpartthatunlessyouhaveobtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the jsTOR archive only for your personal, non-commercial use Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at Each copy of any part of a JSTOR transmission must contain the same copyright notice that ap on the screen or printed page of such transmission STOR is an independent not-for-profit organization dedicated to and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor. org http://www.jstor.org Wed Dec2712:12:252006
Money, Credit, and Prices in a Real Business Cycle Robert G. King; Charles I. Plosser The American Economic Review, Vol. 74, No. 3. (Jun., 1984), pp. 363-380. Stable URL: http://links.jstor.org/sici?sici=0002-8282%28198406%2974%3A3%3C363%3AMCAPIA%3E2.0.CO%3B2-W The American Economic Review is currently published by American Economic Association. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/aea.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is an independent not-for-profit organization dedicated to and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support@jstor.org. http://www.jstor.org Wed Dec 27 12:12:25 2006
Money, Credit, and Prices in a Real Business Cycle By robert G. KING AND CHARLES I PLOSSER* An important recent strain of macroeco- the analysis is on the banking system, build- nomic theory views business cycles as arising ing on the earlier work of James Tobin(1963) from variations in the real opportunities of and Eugene Fama(1980). In our real busi the private economy, which may include ness cycle model, monetary services are shifts in government purchases or tax rates privately produced intermediate goods whose as well as technical and environmental con- quantities rise and fall with real economic ditions. These models are often viewed as developments incomplete or wrong because they do not In the absence of central bank policy re generate the widely emphasized, but not sponse, the model predicts that movemen easily explained, correlation between the in external money measures should be uncor quantity of money and real activity related with real activity. Some preliminary This paper integrates money and banking empirical analysis (using annual data from into real business cycle theory. The result is a 1953 to 1978) provides general support for class of models that can account for the our focus on the banking system since the correlation between money and business correlation between monetary measures and cycles in terms that most economists would real activity is primarily with inside money. label reverse causation. The main focus of Our proposed explanation of the corre lation between money and business fluctua- Department of Economics and Graduate School of tions stands in sharp contrast to traditional theories that stress market failure as the ke Rochester, NY 14627. A preliminary version of this to understanding the relation and interpret paper was presented at the Seminar on Monetary The- monetary movements as a primary source of ory and Monetary Policy, Konstanz, West Germany, impulses to real activity. Given the con- Robert barro, Herschel Grossman, John Long, benne troversies surrounding the main contending McCallum, anonymous referees, and participants of hypotheses concerning money and busines cycles-the incomplete information frame- Pennsylvania, Harvard, and Princeton. The National work of Robert Lucas( 1973)and Keynesian Government Policy and Business of the University of Sticky wage models as revitalized by Stanley Rochester have supported this research. The above indi- Fischer(1977)-it seems worthwhile to con viduals and institutions should not be regarded as neces- sider alternative hypotheses. 3 sarily endorsing the views expressed in this Robert Lucas(1980)provides an ov general equilibrium approach to business cycles work by Fynn Kydland and Edward Prescott (1982 )and tions in money demand including those arising from g and Plosser(1983)illustrate ns in real activity = an mimic key elements of business cycles. in In our view, there are good reasons for dissatisfac tterns of persisten with existing macro c ea that monetary quantities are endogenous is ities, from the textbook reliance on exogenous values to models typically rely on implausible wage or price rigid old one. but has received little the recent more sophisticated effort of Fischer (197 find it useful to categorize earlier stories into two broad that relies on existing nominal contracts. As Barro(1977) points out, a key feature of the explanations that stress central bank policy odel is that agents select contracts that do not I fully or example, James Tobin (1970) provides an ploit potential gains from trade. In addition, Costas em shasizes central bank policy response. Tobins determin- ment contract perceived monetary dis- tic treatment involves the turbances do not Recent analyses of monetary nonneutrality that stress ence-aggregate demand. In Fischer Black's(1972) expectation errors based on "imperfect information analysis, external money passively responds to all varia- ( Lucas, 1977, provides a summary of this viewpoint 363
364 THE AMERICAN ECONOMIC REVIEW JUNE 1984 The organization of the paper is as fol- the output of the financial-banking indu lows In Section I we describe a simple model is an input into production and purchase of that is capable of generating real business final goods. This view is consistent with the cycles. The model is used to discuss corre- general focus on prod duced inputs and sec- lations between an internal monetary quan- toral interactions that is the hallmark of real tity and real activity. In Section II, with fiat business cycle model money included in the model, we analyze the elation between monetary quantities, out A. Final Goods Industry ut,and the price level in both an unregu lated and regulated banking environment. In The single final product (y)is produced Section Ill we discuss some of the empirical by a constant returns to scale production plications of the theory and provide a process that uses labor(n), capital(k), and preliminary analysis of the postwar U.S. ex- transaction services(d)as inputs. The pro- duction technology is summarized by I. The Real economy In this section we describe a simple model where k, is the amount of capital, nyr Is the economy in which business cycles arise as a amount of labor services, and w in the onsequence of the intertemporal optimizing amount of transaction services used in the ehavior of economic agents. Our model has final goods industry. Capital services are two productive sectors with one intermediate measured in commodity units llocated to and one final good. The output of the final production at time t, labor services are hours goods industry is stochastic and serves as worked, and transaction services can be ther a consumption good or as an input viewed as the number of bookkeeping entries into future production. The output of the made( described more fully below ) We also financial industry is an intermediate good make the standard assumptions of positive called transaction services that is used by and diminishing marginal products to each services arises because these services econo- dated by the time of their realization ct to firms in the final goods industry and by y factor. The production process is subj households. The demand for transaction two random shocks, p, and 5,+1 mize on time and other resources required to Transaction services in (1)are viewed as accomplish hange of goods. an intermediate good purchased by final good Recent real general equilibrium theories of producers from the financial industry (to be the business cycle(such as Finn Kydland described below ). Although not involved di- stress produced inputs and interrelations be- same sense as labor and capital, trans tween sectors as central to understanding the services are part of a cost-reducing ac persistence and comovement of macroeco. similar to other organizational and co nomic time-series. The simple model econo- inputs ny that we study has only one final product The sequences() and(5) are assumed and thus does not possess such a rich set of to be strictly positive stationary stochastic dynamics or sectoral interactions. Neverthe- processes that are mutually and serially inde less, the framework embodies our view that pendent with E(D)=E(5)=1. The roles played by the two shocks are quite different similarly rely on an apparent failure in the market for At this point it is sufficient to note that p information. For example, information on monetary alters expected time t +l output and affects tatistics is cheap and readily available. King(1981) time t input decisions by altering intertem demonstrates that in Lucas'(1973)model, real outp poral opportunities. On the other hand, 5, ole monetary information. John boschen and herschel represents the basic uncertainty of the pro- rossman(1982)empirically investigate this proposition duction process by altering output in an nd find that it is rejected by the data. unexpected manner. The multiplicative na
VOL,74 NO. 3 KING AND PLOSSER: MONEY CREDIT AND PRICE 365 ture of the randomness in total production financial industry has a supply curve that is implies a technological neutrality of the horizontal at a particular rental price, P* shocks with respect to individual factors of Although at this stage of our analysis we production. Alternatively, different stochas- focus on the flow of transaction services, the tic elements could be associated with particu- transaction(banking)industry typically(but lar factors not necessarily) provides these services in Production is assumed to be under super- conjunction with portfolio management or ision of identical competitive firms. Firms intermediary services. It is convenient te by selling claims against the future imagine, therefore, that the financial industry output and using the proceeds to purchase holds claims(shares)on the probability dis- factors of production. Labor, capital, and tribution of output and issues other claims transaction services are rented at rental prices (deposits). In the process of market ex- qr, and p,, respectively. Each firm is change, the claims that individuals and firms assumed to sell one unit of claim for each hold on the bank's portfolio(deposits)are unit of expected output as determined by altered through simple bookkeeping entries f(kw, nun, du), which amounts to defining a Banks pass on to depositors the return to the share" in the firm. If the market price of portfolio of assets less a fee for transactio claims is u, the firm faces a static maximiza- services tion problem involving the choice of inputs The structure of the financial industry im- hat maximizes profits, U(kyn, dur) lies that the direct cost of bookkeeping w,nyr-q, kyr-p,dyr. The assumption of con- services, P,, does not depend on the char- stant returns to scale implies that the firm acter or composition of the bank's portfolio the price u*, corresponding to minimum unit there is no reason to expect homoge has a supply of claims that is horizontal As discussed by Fama(1980), it follows tha cost at prices qr, w, and p deposits in an unregulated financial indust More generally, this conclusion holds so long B. Financial Industry as the respective portfolio costs and transac tion services are borne by portfolio holders The financial industry provides accounting and transaction users ervices that facilitate the exchange of goods by reducing the amount of time and other resources that otherwise would be devoted to market transactions. The production of this The individual households in the model intermediate good which we call transaction e consumers, suppliers of labor services ervices, is summarized by the production and capital goods, purchasers of transaction function(2)in which nd, and kdr are the services, and ultimate wealth holders. The amounts of labor and capital allocated to the representative individual is assumed to be financial sector: infinite lived and possess the intertemporal utility function h ∑B(x,+, This instantaneous production structure em odies the hypothesis that production of where B is a fixed utility discount factor and ransaction services requires less time than u( is a single period utility function that production of the consumption-capital good. depends on consumption(x,+) and leisure Technological innovation in this industry is (n-ni+)with n indicating the total hours captured by Ar which is assumed to be a available in each period. The utility maxi- strictly positive stochastic process with a mand is the expected utility measure E, U mean of one. Finally, we assume(2)repre- where et denotes the conditional (rational) sents a constant returns to scale structure so expectation based on all information avail that, at given factor prices w, and qu, the able at time 4
THE AMERICAN ECONOMIC REVIEW JUNE 1984 The representative agent arrives at date t D. Equilibrium Prices and t th total wealth equal to the sum of current realized output(y)and the depreciated value Analysis of dynamic, stochastic general of the previous period's capital stock(k equilibrium models is a difficult task. One Sk-1). The agents current decisions involve strategy for characterizing equilibrium prices the selection of the levels of consumption and quantities is to study the planning prob- (x, )and of total effort (n, )as well as alloca- lem for a representative agent(see Lucas tion of effort to market and nonmarket activ- 1978, or Long and Plosser). This procedure ities. These decisions imply a level of saving is valid so long as the competitive equi that then must be efficiently allocated, along librium is Pareto optimal. The planning with current wealth, to purchases of invest- problem can also be used to generate specific ment goods (i,)and financial assets (for equilibria if explicit functional forms for example, real bonds, shares, etc. preferences and technologies are assume Households are assumed to combine time We do not pursue this strategy in detail as and transactions services to accomplish pur- our objective is more modest. Instead, w chases of consumption and investment goods. make a number of simplifying assumptions In particular, the time required for this non- regarding the general framework proposed market activity is above that allow us to highlight the condi (4)n21=r(dn:/(x1+1)(x1+i), tions necessary to obtain certain business cycle comovements in general equilibrium The state of the economy at date t is where T'<0,T"<0. Our individual selects summarized by the values of four variables an amount of transactions services dht so as y,(1-8)k-1,P,, and A,. The first is a measure of national income the second is + p dhr. So long as hours are freely variable, the current stock of depreciated capital, , is w, is the opportunity cost of effort, and a technical factor affecting current opportu this minimization problem can be treated nities to transfer resources intertemporally separately from the household,'s general and A, is a technical factor influencing the allocations.( However, efficiently selected production of transaction services.The ansactions patterns will have wealth and agents vector of decisions variables is(nyr substitution effects on desirable household ndr, n,, dn, dyn,ky, kd) allocations.) In order to simplify the problem, we make Minimizing the total cost of transactions three assumptions that are sufficient to re- activities implies a derived demand for duce the state vector to two elements and the purchases of transaction services of the form decision vector to two elements while pre- dhi=(P/w)(x,+i,), where g=(T")I< serving the essential features of the model 0. Similarly, hours allocated to transactions First, we assume a depreciation rate of 100 activities are proportional to expenditures, percent, eliminating(1-8)k-I as a state taking the form n*=T(g(p,/w))(x,+iD) variable. Second, we assume that transaction The presence of transaction costs for the services are produced determi urchase of consumption and investment 1, for all () and depend only on labor input goods implies that the total cost of a unit of (d, =hon dt ) Deterministic production of 1+[w,T(g(p /x greater than unity (i.e. variable and the simplified production tech- ection nology implies that the competitive price is of an optimal pattern of consumption(x,), p*=w, ho. This implies that households(and folio allocations involves the usual sort of tion services in fixed proportiong d transac- total effort (n, =nur+nar +nr), and port- firms below)use time and purcha intertemporal efficiency conditions with the The third assumption is to restrict the final exception of this modification. Fischer(1982) goods production function to employ finan- provides an interpretation of the altered cial services in a manner that is symmetric to efficiency conditions in a similar context
VOL. 74 NO. 3 KING AND PLOSSER: MONEY, CREDIT, AND PRICES households)purchase transaction services, current inputs, future production is higher dy, and allocate labor services to transaction and the current returns to additional units of activities in fixed proportions where the scale factors of production are higher. These variable corresponds to total payments to offsetting effects are analogous to the income actors of production and thus is closely and substitution effects of a real interest rate related to next period,s output (for house- change. Essentially, the small impact of a holds the scale variable is x, +i,). The sec- shift in p, on the amount of output allocated ond and third assumptions eliminate n to capital accumulation (akut/a% =0)re- dhr, du, and kdt from the vector fects the idea that the income and substitu decision variables tion effects on consumption are roughly There is a discounted dynamic program- ffsetting. On the other hand, the substitu- ming problem whose solution corresponds tion effect of such shifts on labor supply is the competitive equilibrium of this simplified presumed to dominate so that anut/ap, >0, model economy. The decision rules for the which generates procyclical work effort problem are stationary functions of the state Once quantity behavior is determined, variables y, and p,. Rather than solve this equilibrium factor prices, interest rates, and problem for an explicit specification of pref- share prices are straightforward to erences and technologies, the essential fea- In particular, competitive prices tures of the interactions between the final to marginal rates of substitution n at optimal goods industry and the financial industry can planned quantities. For example, there is a be analyzed by employing the following re- riskless commodity interest rate r, that we strictions on the decision rules; 00, and u)u]=(o, -u)/ur. In our setup, this ex- These restrictions follow from assumptions pected return exceeds the riskless rate, bout preferences and production opportuni- E,(ru)>r, since the holders of these shares ties. For example, an increase in the amount must be compensated for bearing production of the initial stock nvolves additional risk wealth so that the consumption of final prod uct and leisure are expected to rise. Agents Real Business Cu e 2d the nsiae however, choose to spread some portion of this wealth increment over time and do so by cated to capital services so that 0 Analogously, an increase in involves 1)leads to higher net investment than would both wealth and substitution effects. Given otherwise have been the case. Furthermore, that real output increases and exhibits positive serial correla 4 This result also requires that the amount of time tion. during the course of such an economic old is small relative to total time allocated to market expansion, the volume of credit( shares)is also high as firms finance relatively large
THE AMERICAN ECONOMIC REVIEW JUNE 1984 mounts of goods in process. This positive econometricians(Christopher Sims, 1972 correlation between the total volume of credit 1980), and monetary historians (Milton and real activity is potentially an important Friedman and Anna Schwartz, 1963)view prediction of our framework, especially since monetary variables as"leading"measures of evidence presented by Benjamin Friedman real activity One way of generating a diferent timing between total credit and output than be- pattern is through shifts in the intertemporal tween the individual components of credit opportunities of the economy as a whole and real activity Real events of this type, respresented by e The movements in final goods production alter agents'allocations of leisure and con- duces a higher volume of transaction sumption between the present and the future services demanded by firms and households for a given level of national wealth. A higher Thus, our model generates the positive co- than average shock (, >1), under the as- movement of output with measures of sumptions outlined above, expands hours bank clearings, long noted by empirical re- worked with little accompanying change i ample, Wesley Mitchell, 1930, pp. 116-51). cial services are an intermediate Phuc? searchers in the business cycle area(for ex- consumption or capital. The fact that fina Finally, real rates of return move in a which can be produced more rapidly than countercyclical direction as agents'oppor- the final product-leads tunities to spread wealth over time are sub- the quantity of such services and of bank ject to diminishing returns (i. e, total time is deposits. Consequently, movements in hours in fixed supply) worked, interest rates, and security prices, The predictions of our model focus on the deposits-financial services, and trade credit flow of transaction services. It is important all occur prior to the expansion of to provide a link between these flows and the The subsequent increment to time t+1 stock of deposits that has been the more wealth(stemming from the joint impact of traditional focus of monetary analysis. It is the exogenous shift, P, and agents'responses convenient to assume that the stock of de- to that shift) works much like the above posits IS proportional to the flow of transac. discussion of unexpected output events tion services and can be represented by Yd Typically, we suspect the initial phases of Under this assumption, our model implies business fluctuations incorporate a combina- that the volume of inside money(deposits)is tion of both types of shocks (i. e, shifts in positively correlated with output with a rough current and expected future production pos coincidence in timing. More generally, this sibilities) may reflect the role of deposits as a store of IL. Currency, Deposits, and Prices process At least some cycle episodes, however, are In order to investigate the relation be- commonly viewed as involving a different tween nominal aggregates and the real busi timing pattern. For example, traditional ness cycle it is necessary to augment the business cycle analysts (Arthur Burns and Mitchell, 1946), modern time-series macro- sIms(1980)discusses reverse causation and output working through central bank esent setup is a first step toward the type It is sufficient for our purposes that f small-scale general equilibrium model that is neces- any monotonic in- sary to evaluate the reverse causation argument. creasing function. Although this assumption is a conven- 7 We deliberately employ the idea of a"leading vari- tional assumption with physical capital, it is nevertheless able"in ure the common ad hoc element ling. For example, tran elements of these alternative discussions action services le, require any specifie It is commonly stressed that asset prices and returns checking accounts that incorporate information about predictabl equilibrium model d mation is also incor- in the volume of debits re porated into all quantity decisions such as effort, con the stock of deposits sumption, an
VOL. 74 NO. 3 KING AND PLOSSER: MONEY, CREDIT, AND PRICES 369 hypothetical economy developed above. In portional link between financial services(d, this section, a non-interest-bearing govern- and deposits(yd, ) the effective cost of a unit ment-supplied fiat currency(dollars)is intro- of deposit services, p, is influenced by this duced and the factors affecting its value are reserve regulation. In the absence of regula analyzed ions p,=p, where P, is the rental price of In order for currency to be a well-defined deposit services in the competitive env economic good, and thus to have a de- ment of Section I terminate price in terms of a unit of output ransactions cost minimization by house- (1/P), there must be a demand function for holds implies real demands for currency and currency that reflects the economic value as- financial services of the following forms signed to the services of currency by eco- nomic agents. For simplicity, we assume that households are the principal demanders of (6a)c1=l(R1/(1+R1),p1,w)y currency. To generate ble demand for currency, real currency is viewed as a sub stitute--but not a perfect one--for transac- (6b) dh-8(R,(1+R),P,w)y, tions services purchased from the financial ector. In particular, currency yields a real ervice flow in that there are some transac- The signs below the arguments denote the tions(either of magnitude or character)that signs of the partial derivative(for example, are more efficiently carried out using ac,/ap, >0). These signs are insured if T( rency than the accounting system of is such that currency purchasing por hange. We revise the household's time spent financial services are substitutes n transactions activities, equation (4), to re- The structure of the markets for currency flect these expanded opportunities and financial services is analogous to Fama (1980). As he points out, determinacy of the (5)nn1=T(an,/y,c1/)y price level is insured if the government fixes the nominal quantity of currency-direct or where y, is the total market transactions of indirect regulation of financial sector quanti our household, c, is the stock of currency ties and/or characteristics is not necessary. urchasing power, and dht is the flow of Nevertheless, regulations can be important inancial services purchased from the finan- for two reasons. First, regulations produce a ial industry differentiated class of suppliers of financial Thus, a household minimizing its cost services(banks) whose deposits are some transaction activities will select amounts of times described as inside money. Second, that is analo- regulations can influence the price level by gous to our earlier discussion. The demands altering the effective rental price of financial for each input will be a function of the rental services price of real currency, R /(1+R), the The analysis below focuses on the implica effective cost of financial services P, and the tions of alternative banking structures for the opportunity cost of time, w behavior of currency, deposits, and prices In formin g these rental prices, two im- For clarity, the bulk of the discussion is portant assumptions are made. First, there is conducted under the assumption that the a market for one-period nominal bonds that treasury-central bank maintains a policy of bear interest rate R. This nominal rate is the controlling the issue of nominal currency so sum of the real component, r, and an ex- that the stock of currency(C=P,,)is an pected rate of inflation, E(T). Second, if exogenous random variable. This assumption banks are required to hold non-interest-bear- means that the behavior of the price level ing reserves, the returns earned by depositors can be analyzed by investigating equilibrium may not match market rates. Given the pro- in the currency market. Other models of entral bank behavior are discussed in Part B yWe assume that T1 <0, T2<0, Tn <0, Tz< 0, and below. In all of our discussions, however,the price level is best viewed as being set in the
THE AMERICAN ECONOMIC REVIEW JUNE/984 market for that nominal asset whose quan. The resulting increased inflation leads to a tity the central bank seeks to control rise in the nominal interest rate. R. which implies a fall in the demand for real currency A. Money and Prices-Unregulated Banking and a rise in real transaction time allocated to transaction activities since 4. In an unregulated banking environment an increase in real transaction services in- we assume that the deposit industry would volves the use of real resources, the economy hold virtually no currency. Consequently, the is made worse off by sustained inflation. We determination of the price level involves the assume, however, that this increase in the requirement that the real supply of currency size of the financial sector has no important (C/P) be equal to the real demand for imp o It is not obvious that this is a good cations for the real general equilib currency given by(6a)above. The equi librium price level is then assumption from an empirical point of view Nevertheless, it does serve to bring into sharp P=C1/1(·) focus the distinction between inside and out. side money, particularly with respect to the where 1()is the demand function for neutrality and super-neutrality of govern currency Using the arguments of l(.)we ment currency Issue rewrite this condition as B. Money and Prices- Regulated Banking P,= P(Co,R Pr, w,) In an unregulated environment the price level is determined in the currency market The signs of the respective derivatives in(8) and deposits play no essential role. There re straightforward and warrant little ex- are, however, a number of regulations that planation serve to distinguish banks from other finan An important feature of (8)is the absence cial intermediaries and thereby inside money of nominal demand deposits. Thus, as from credit. Here we discuss the extent to stressed by Fama(1980), there is no need for which these regulations alter the nature of government control of banking or the supply price level determination. As it turns out, the of deposits to insure a determinate price impact of regulations depends on (i)the level. Banks, in a competitive, unregulated interaction of banking regulation with the nvironment,simply pass portfolio returns external money supply policy of the central on to their depositors less a fee charged for bank-treasury, and (ii) the extent to which the provision of transactions services, so that government mandates can be offset by coun- P,=p,. The only way in which developments tervailing private substitutions n the banking sector are relevant to price level determination is through variations in 1. Portfolio Regulations and Reserve Require the cost of financial services(p, ) ments. It is useful to start by discussing a set This view of price level determination im- of regulations that do not have any im- plies that once and for all changes in the portant consequences for the price level quantity of currency are completely neutral The volume of transaction services(d, and 10In other words, we assume that our model is ap- deposits(yd, are determined solely by vari- proximately "super-neutral"in the language of mone Section 1. Nevertheless, the mome ussed in this literature does not provide a clearcut guide to the quantity f deposits (Prd,) is likely to be positively ple, Tobin (1965), has argued that an increase in infla correlated with real activity if currency is n will lower real rates of and raise capital determined exogenously and prices are not formation, by lowering the rea trast, Alan Stock On the other hand, sustained increases in saving groc riun which money is an i aps a and, hence the growth of currency may have real effects. depresses capital formation
VOL. 74 NO. 3 KING AND PLOSSER: MONEY, CREDIT, AND PRICES 371 Suppose that the government specifies the Let B, - 8(PYd, be the nominal stock of risk composition"of the underlying assets bank reserves and H,=B,+ c be the exoge- against which deposits are claims. As long as nous total of bank reserves and currency agents can offset this restriction by rebalanc- Under this regime, the price level may be ing the contents of their portfolios (i.e, the viewed as arising from the requirement that distribution of total wealth between the the total private demand for fiat money banking sector and other portfolio managers), equals the supply. That is, H,=Pcr then this regulation will have no impact on ydu= Plc+ B/P. The librium any real variables or the price level. How- price level can be expressed as ever, such restrictions may serve to dis- tinguish inside money for other forms of (9) P=H/(1()+(B,/P)) credit On the other hand, restrictions specifying or using the arguments of l(), that banks must hold some fraction, say g, of their nominal asset portfolio in the form of (10) P=P(H,,n, R, Pr, w,, (B, /P) non-interest-bearing reserves issued by the entral bank may have important effects. For example, the central bank could specify that Once again the signs of the partial deriva reserve accounts are deposits of securities tives are straightforward. Note, in particular, with nominal interest accruing to the central that an increase in the demand for real bank.This mechanism is one way of impos- reserves(B, /P)holding high-powered mon- ing a deposit tax with the consequence that ey fixed necessitates a fall in the price level the cost of deposit services would be p, A central bank policy of controlling high Such a deposit tax results in a reduction in powered money, therefore, implies that the the size of the banking sector and an increase equilibrium price level is determined in the in the real demand for currency. The impact market for this exogenously controlled nomi of this reserve requirement on price-level de- nal quantity. Consequently, real activity (in- termination depends on the central bank cluding real deposit services and real de- policy. For example, if the treasury-central posits)is neutral with respect to changes in bank makes currency in the hands of the high-powered money and, as in the case of public an exogenous quantity, unresponsive currency, we assume that high-powered mon- to developments in the banking sector, then ey is approximately super-neutral under this the price level continues to be determined by regime the requirement that the real stock of cur- As discussed in Fama(1980, pp 52-53), rency outstanding(C/P) be equal to the there are other central bank policies that real demand. In these circumstances, the be- could be used to make the price level de- havior of deposits and deposit services would terminate. In particular, the central bank be similar to that in an unregulated banking could choose to make nominal bank reserves an exogenous quantity and supply currency demand. In this case(which some argue 2. Alternative Central Bank Policies. The are the current policies of the Federal Re- currency market determines the price level if serve), the price level can be viewed as being the central bank is assumed to make cur- determined in the market for reserves. the rency an exogenously controlled quantity. equilibrium price level would be determined There are, however, other control methods by the exogenous supply of nominal reserves available to the central bank. For example, if (B,)and the total real demand for deposit the central bank combines a reserve require- services. ment with a policy of controlling the sum of currency and nominal bank reserves(high powered money), then the price level can be n We have not yet analyzed price-level determination et f when the central bank attempts to control the interest ewed as being determined in the market fo rate. However, this may be important to an appropniate high-powered money. empirical investigation of some time periods
