Monetary Policy, Overlapping Generations, and Patterns of Growth

Abstract

This paper investigates the role of monetary policy in economic growth. Using an infinitely lived overlapping-generations model with a simple convex technology that can yield endo- genous growth, we show that money supply behaviour of the government may have significant effects on the long-run economic growth. In addition to the effect on the long-term growth rate of the economy, the policy may determine whether the economy stays in the exogenous growth process restricted by the growth rate of labour supply, or realizes the endogenous growth that sustains continuous growth of pep capita income and consumption. effect of inflation on capital accumulation has been one of the central topics in macroeconomics. Using an ad hoc model, Tobin shows that a rise in the rate of inflation deepens capital formation, whereas Sidrauski presents an opti- mizing model in which money is superneutral; that is, inflation has no effect on capital formation in the long run. These studies have been extended by a number of studies such as Dornbusch and Frenkel (1973) and Wang and Yip (1992). However, the concern of these studies is restricted to the analysis of the level effect of inflation on capital accumulation. Recent developments in endogenous growth theory present a useful analytical framework for re-examin- ing the effect of inflation on capital accumulation and economic growth. In contrast to the strong emphasis on the importance of fiscal policy for long-run economic growth seen in Mino (1989), Barro (1990) and King and Rebelo (1990), the role of monetary policy has been mostly ignored in the endogenous growth literature. Recalling that the effect of money growth on capital formation has been the central issue in money and growth literature, it is rather curious that recent studies on endogenous economic growth focus exclusively on the real side of the economy. There is, however, a small number of authors investigating the role of money in endogenously growing economies. Marquis and Reffet (1991) and Mino (1991) introduce money into two-sector models involving human capital accumulation via a cash-in-advance constraint. They conclude that an increase in the rate of nominal money supply (generally) depresses the long-term economic growth, as long as the cash-in-advance con- straint applies to investment demand for either physical or human capital.' Wang and Yip (1991) extend the Uzawa-Lucas model of endogenous growth by assuming that households allocate their available time between production, transaction and human capital formation. The transaction time is assumed to be a decreasing function of real-money balances, and therefore a reduction in real balances arising from an increase in the monetary expansion rate increases c? The London School of Economics and Political Science 1995