Comment on 'On the Fit of a Neoclassical Monetary Model in High Inflation: Israel 1972-1990.'(response to Article in This Issue, P. 725) (Dynamic Effects of Monetary Policy)

By Fuerst, Timothy S. | Journal of Money, Credit & Banking, November 1997 | Go to article overview

Comment on 'On the Fit of a Neoclassical Monetary Model in High Inflation: Israel 1972-1990.'(response to Article in This Issue, P. 725) (Dynamic Effects of Monetary Policy)


Fuerst, Timothy S., Journal of Money, Credit & Banking


During hyperinflation the amount of real cash balances changes drastically. At first sight these changes may appear to reflect changes in individuals' preferences for real cash balances -- that is, shifts in the demand function for the balances. But changes in real cash balances may reflect instead changes in the variables that affect the desired level of the balances. . . . The hypothesis [is] that changes in real cash balances in hyperinflation result from variations in the expected rate of change in prices. (pp. 29-33)

The above quotation is drawn from Phillip Cagan's (1956) classic study, "The Monetary Dynamics of Hyperinflation," first published some four decades ago. Cagan's conclusion is truly remarkable -- out of the apparent utter chaos typical of hyperinflations, Cagan argues that there is stability, a stable relationship between real money demand and expected inflation. The work of Benjamin Bental and Zvi Eckstein is in this Cagan tradition. The dates and places have changed, but the underlying result remains the same: the high inflation experienced by Israel in the recent past is a manifestation of a stable money demand curve interacting with a rapidly growing supply of money. In these remarks, I will first review the theoretical arguments for stability (arguments that are as applicable to Cagan as they are to Bental-Eckstein), and then turn to a few more pointed comments about Bental-Eckstein's contribution.

1. Stability?

In the volume Studies in the Quantity Theory of Money, the article immediately preceding Cagan's study of hyperinflations is Friedman's (1956) restatement of the quantity theory. Approaching the issue from a portfolio perspective, Friedman argues that the demand for money is a function of a long laundry list: total wealth, the ratio of nonhuman to human wealth, the nominal return on equity, the nominal return on physical goods, and the nominal return on short- and long-term bonds. Friedman suggests that this is a stable empirical relationship, but given the forecasting problem subsumed into, for example, the human wealth variables, there is little hope that Friedman will prove to be correct.

In sharp contrast, Bental-Eckstein's money demand function [given by their equation (13)] is a function solely of current consumption and the, current short-term bond rate. The linkage between these two views of money demand is the permanent income hypothesis: money demand is a function of wealth and these other asset returns only through their effect on the consumption decision. This approach separates two logically distinct decisions: (i) the consumption-savings choice, and (ii) the cash balances versus number-of-trips-to-the-bank choice. This transactions approach to money demand yields a relationship that depends on only two currently observable variables, and thus provides some confidence that this relationship might be stable.(1) It is with this theoretical hunch for stability in hand that we can now turn to the work of Bental-Eckstein.

2. Details of Bental-Eckstein's Work

Bental-Eckstein present a partial equilibrium model in which infinitely lived households have preferences over consumption, leisure, and real money balances. The first-order conditions to the problem include a demand for money [equation (13)] and a supply curve for labor [equation (15)]. To begin, I have a few specific comments on the functional forms used to generate these relationships.

One unusual feature of the money demand function is that the interest elasticity is decreasing in the rate of interest. This is an artifact of the timing implied by the model. Real money balances at the end of the period enter into the utility functional. On intuitive grounds it seems that a more plausible choice would be to assume that beginning-of-period balances enter into the utility function. This minor change will transform equation (13) into a demand function with a constant interest elasticity of unity. …

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