Monetary policy and endogenous time preference

Abstract

PurposeThe purpose of this paper is to derive the real implications of inflation targeting using optimizing models characterized by endogenous time preference.Design/methodology/approachTo ensure consistent consumption and savings behavior, the rate of time preference is modeled as an increasing function of real wealth.FindingsThe results are not uniform and depend on the methods for modeling money in the general equilibrium framework; money in the utility function (MIU) and cash‐in‐advance constraints (CIA). With MIU, time preference wealth effects link the monetary and real sectors by endogenizing real interest rate. Monetary growth raises steady state capital and consumption by the Tobin effect. However, if money is introduced through CIA constraints, inflation policies are sensitive to the structure of the constraint itself. If the constraint applies to consumption and capital purchases, monetary growth lowers the steady state demand for both commodities and reverses the Tobin effect. If the constraint applies only to consumption goods, the same monetary policy is superneutral. This time preference specification has important advantages. It is consistent with the literature that integrates reinforcing wealth effects into aggregative models using ad‐hoc consumption or savings functions. Allowing the rate of time preference to depend positively on real wealth implies that optimizing behavior, not ad‐hoc specification yields wealth effects that endogenize the real interest rate and generate a Tobin effect. This time preference specification provides optimizing foundations for modeling savings as a decreasing function of real wealth, which is empirically verifiable and consistent with empirical predictions of consumption as an increasing function of real wealth.Originality/valueThis paper demonstrates the different effects that monetary policy maintains on steady state capital, consumption and real balance holdings in economies characterized by an endogenous rate of time preference.