Academic journal article Journal of Money, Credit & Banking

Tobin's Imperfect Asset Substitution in Optimizing General Equilibrium

Academic journal article Journal of Money, Credit & Banking

Tobin's Imperfect Asset Substitution in Optimizing General Equilibrium

Article excerpt

A CENTRAL MESSAGE of James Tobin's "General Equilibrium Approach to Monetary Theory" was that "[t]here is no reason to think that the impact [of monetary policy] will be captured in any single [variable] ..., whether it is a monetary stock or a market interest rate" (Tobin 1969, p. 29). This message was a departure from both the simplest quantity-theory setup--where nominal aggregate demand moves in step with the nominal stock of money--and the traditional ISLM framework, where the aggregate demand for output depends on a single, representative interest rate.

In many respects, the "New Keynesian" or dynamic stochastic general equilibrium models (DSGE models) used today (see Walsh, 2003, and Woodford, 2003, for extended treatments) represent advances on the models that Tobin criticized. For example, in contrast to the simple quantity theory, the LM relationship in the New Keynesian model implies an interest-elastic and stochastic velocity function. And as Rotemberg and Woodford (1999) and Svensson (2000) emphasize, the presence of forward-looking behavior in the optimizing IS equation means that aggregate demand can be interpreted as depending on a type of long-term real interest rate. In that sense, modern models do admit a distinction between different asset yields. In addition, in contrast to Tobin's work, these functions are worked out from explicit stochastic optimization problems of agents, while the aggregate supply portion of the model--typically based on Calvo (1983) staggered price contracts--improves on the absence of an aggregate supply specification in Tobin (1969).

At a deeper level, however, New Keynesian systems are vulnerable to Tobin's criticism of earlier-generation models. While a (real) "long-term rate" appears in the model, it does so only as a stand-in for the expectation of the path of the current (real) short rate. Deviations of the long-term interest rate from the expectations theory of the term structure are not recognized. In effect, the arbitrage relations in the model restore the two-asset structure of traditional IS-LM, leaving a framework like that criticized by Tobin, where "all nonmonetary assets and debts are ... taken to be perfect substitutes at a common interest rate plus or minus exogenous interest differentials" (Tobin 1982, p. 179).

In this paper, we develop the New Keynesian model to allow explicitly for imperfect substitutability between different financial assets. As Kashyap (1999, p. 190) noted, "Tobin has long pushed the view that different securities should be treated differently," and we represent this view by allowing for imperfect substitutability between short-term and long-term financial securities. Furthermore, we specify the imperfect substitutability in a manner which allows for Tobin's view that an expansion of one asset's supply affects both the yield on that asset and the spread or "risk premium" between returns on that asset and alternative assets.

Policy debates in recent years have given these issues a prominence that was absent when Tobin's paper was first published. Macroeconomic modeling after 1969 tended not to follow up the implications of imperfect substitution between assets, with notable exceptions including Brunner and Meltzer (1973) and Friedman (1976, 1978). This probably reflected the convenience of the perfect-substitute baseline, especially for dynamic general equilibrium analysis; and also the fact that many of the key debates of the past three decades--e.g., the natural rate hypothesis, staggered contracts, and inflation bias--focused on the aggregate supply specification (i.e., price/output interaction, rather than output/interest-rate interaction). For these debates, how private reactions split a policy-induced injection of nominal spending into prices and output was of first-order importance; how monetary policy creates the additional spending is second-order.

Recent discussions of the monetary transmission mechanism have restored the specification of aggregate demand to a first-order issue. …

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