Consumer behavior in a monetary economy and smoothing of composite consumption

Abstract

This paper analyzes consumer behavior in a monetary economy when money yields utility and preferences are recursive and represented by a utility functional composed of instantaneous discounting and utility functions. The Keynes–Ramsey rules of consumption and real balances are derived, which are combined and integrated into a consumption–wealth relation. It is demonstrated that due to intertemporal arbitraging the monetary component of wealth vanishes, hence that money affects consumption, not through wealth effects but through the proportion of wealth allocated to consumption, which is affected by the paths of real interest rate and the time rate of change of the nominal interest. To isolate the case in which money is neutral to real decisions despite the fact that money yields utility, we define what is meant by neutrality and elicit the restrictions on the forms of the two functions that bring about this neutrality. Likewise we examine the property of the homotheticity of preferences in an intertemporal context, again eliciting the restrictions that this property imposes on the forms of the two functions. Implications of this analysis for the permanent income hypothesis are delineated by identifying the conditions that need to be met, and this hypothesis is extended to smoothing of composite consumption comprised of consumption and transaction services of real balances. The differences between real and monetary economies are made explicit throughout. We also explore some implications of our model when the scope of wealth is extended to include financial and housing wealth as well as when leisure is endogenized.