Nominal Prices and Interest Rates in General Equilibrium: Money Shocks

Abstract

The outstanding problem of neoclassical monetary theory has been to determine the of changes in the money stock on nominal prices and interest rates. The classic result is that, in the absence of money illusion, contracts fixed in nominal terms, and other such impedimenta, money is neutral. Thus a doubling of the money stock results in a doubling of the nominal price level and in no change in nominal interest rates (except at most for a temporary liquidity effect while the price level is rising to its new level; during the adjustment period the nominal interest rate might temporarily drop). This neutrality result has conventionally been proved in a static framework. In intertemporal models it is necessary to distinguish between static neutrality and dynamic neutrality: if a model displays dynamic neutrality, fluctuations in the money stock immediately induce a proportional change in the nominal price level, and no change in nominal interest rates or any real variable. This property is different from and stronger than static neutrality, which, in dynamic models, states only that if the money stock at all dates is doubled so will be the price level at all dates. The effects of exogenous shocks in the monetary growth rate on nominal prices and interest rates are analyzed. A representative-individual rational-expectations framework is adopted, and a demand for money is generated by entering money in the utility function. The effects of monetary shocks on inflation and interest rates are shown to depend on the autocorrelation of the monetary growth rate: for example, under serial independence the inflation rate equals the monetary growth rate and the nominal interest rate is nonrandom, while under positive (negative) autocorrelation the nominal interest rate is affected positively (negatively) by positive growth rate shocks. * I am grateful to the staff of the Federal Reserve Bank of Philadelphia, to the finance groups at the University of Southem California and Virginia Polytechnic Institute, and to C. J. LaCivita, Dan Peled, John Seater, and Jon Sonstelie for valuable comments on earlier drafts.