Employment, investment, current account and the term structure of interest rates in a cash-in-advance economy

This study examines the effects of alternative monetary policies on employment, capital accumulation, the current account and the term structure of interest rates in a cash-in-advance (CIA) economy. The infinitely lived representative agent framework is adopted, where the agent is empowered with a labour/leisure choice. Two key assumptions are made that enable the analysis to be very attractive using standard techniques involving phase diagrams. First, a continuous time framework is deployed for considerable flexibility, and second, it is assumed that the monetary authority targets the inflation rate.; In the first model, which assumes a closed economy, the effects of monetary policies are worked out. It is shown that an increase in the inflation rate raises the relative cost of consumption. This leads to a decrease in consumption and the labour supply, which in turn reduces the marginal productivity of capital, the return on equities and capital accumulation. In the new steady state, there will be lower levels of consumption, employment, and capital. The effects on the term structure of interest rates are also worked out. In this chapter, I study the effects of monetary policies when the authority targets the nominal interest rate. It is shown that an increase in the inflation rate or the nominal interest rate will have similar effects in the economy.; In the second model, a small open economy is considered. It is shown that an increase in the rate of depreciation of the domestic currency will lead to a fall in consumption and labour supply. The resulting fall in labour supply into the production process reduces the marginal productivity of capital, leading to a fall in investment. With investment adjustment costs, capital adjusts slowly towards its long run level. The fall in labour input also reduces output on impact. Nevertheless, the current account goes into a surplus as the reduction in consumption and investment dominate the decrease in output. The effects of an unanticipated temporary increase in the rate of depreciation of the domestic currency is also studied. It is shown that such temporary changes in exchange rate policies have long term effects. Hence, the model exhibits hysteresis.; The literature on Monetary Theory has emphasised the fact that without labour/leisure choice, the effects of changes in the rate of growth of money on investment and the capital stock are sensitive to the assumptions made regarding the CIA constraints. The third model examines how robust these results are when the representative agent has a labour/leisure choice. The analysis is made by assuming that all transactions, including transactions involving assets, are subject to CIA constraints. Although the model is more complicated, the general results are very similar to those derived with a CIA constraint on consumption alone as demonstrated in the other two models in this study. It can be concluded that with labour/leisure choice, the dynamics of the model seem to be dominated by the reactions of labour/leisure to changes in the inflation rate. This seems to overwhelm the dynamics derived by Stockman (1981) and Abel (1985).