Portfolio Adjustment and Monetary Growth

Abstract

A common feature of disequilibrium monetary growth models (those in which markets need not be cleared at any given moment in time) is the assumption of a simple portfolio adjustment process which generates a flow demand for money from a discrepancy between desired and actual holdings of real balances. However, some care must be taken in incorporating this process into the specification of asset market equilibrium. An implication of the portfolio adjustment process that has been uniformly overlooked is that anticipated real balance flows (e.g. due to inflation or government transfers) during the adjustment period will alter the extent to which wealth holders will need to enter the market to achieve a given adjustment. This is significant because the anticipated accommodation of desired reductions in real balances by inflation during the period of adjustment is potentially an important stabilizing force. As will be shown, this stabilizing force may be sufficiently potent to permit stability of an equilibrium growth model even if inflationary expectations are formed with perfect foresight (a possibility that is excluded in the existing literature). Thus the dynamics of monetary growth have been misunderstood. The insight that there must be sufficient friction in the system if the economy is to be stable is correct, but it has been overlooked that the portfolio adjustment process itself may be capable of providing that friction. It will be sufficient to examine a simple model with three markets, for money, bonds and goods (on the assumption that the wage rate adjusts to continually clear the labour market). It will be apparent that the results generalize to more elaborate economies. The model utilized will be sufficiently general to include several important classes of monetary growth models (in terms of adjustment processes) as special cases, and it will be shown that proper specification of asset market equilibrium will significantly relax the stability conditions in all of these cases.