Inflation and Economic Growth

Abstract

ESPITE the large volume of recent Th literature on economic growth, little has been done to integrate monetary factors in the explanation of the growth process. Most of the growth models are "real" models, in the sense that they manage to ignore the monetary structure of the economy and focus only on real variables. The construction of these kinds of non-monetary models is completely justified if one is able to show that the monetary structure has no effect on the real variables of the system, that money is neutral. The neutrality of the monetary sector is a problem that has been widely discussed in the monetary theory literature. In terms of the standard macroeconomic model, if prices are flexible and if wealth is not an argument in the saving function, a once-and-for-all change in the quantity of money will not affect the real variables of the system. Since a great deal of the growth literature, such as that of Solow (1956) and Swan (1956), assumes that saving is not affected by wealth and, particularly, that the community saves a constant proportion of income, it would seem that ignoring the monetary sector is a proper way of simplifying things. The explanation of the growth process could then be decomposed into two subsets of problems: (1) the determination of the real variables, including the rate of growth of the economy, and (2) the determination of the monetary variables. This paper shows, however, that neglecting the existence of alternative assets to real capital in the neo-classical model of growth, with saving being a constant proportion of income, is not a proper way of simplifying the analysis. The mere existence of outside money, independent of the rate at which the money stock grows or declines through time, will prevent the economy from attaining the Solow-Swan steady state capital stock. The capital stock for which a monetary economy reaches its steady state is always smaller than the one indicated by the Solow-Swan model. It therefore follows that the golden-rule saving ratio is not any more the one that maximizes long run consumption. For long run consumption to be maximized the saving ratio has to be greater than the share of profits in national income. On the other hand, the recent work on economic growth in a monetary economy, by Tobin (1965) and by Johnson (1966), centers on the steady state features of the economy; there is no rigorous discussion of how the economy reaches this steady state, nor of what the conditions are under which this steady state, if attained, will be maintained. Also, since attention is focused on steady state solutions, there is nowhere an analysis of how changing market conditions affect *A first draft of this paper was presented in April, 1966, as a prospectus for the author's Ph.D. dissertation at the University of Chicago. For their helpful comments and suggestions, grateful acknowledgment is given to Hirofumi Uzawa, Arnold Harberger, Robert Solow, and Arthur Treadway. The author also takes sole responsibility for any remaining errors.