A Theory of Financial Innovation and Monetary Substitution with an Application to a Century of Data on the M1-Income Ratio (Preliminary)

I study a DSGE model incorporating a monetary transactions technology in which a representative household invests time to improve its skill (human capital) in making transactions. The model is designed to reconcile salient shortand long-run features of the relationship between money, income, and the opportunity cost of holding money. An econometric reduced form, derived analytically, is revealing for the nature of pathologies perceived by the empirical money demand literature; particularly interesting is the possibility of a moving average root close to the unit circle. The impact elasticity of the M1-income ratio to an innovation to the opportunity cost is about 0:1, whereas the long-run response to a unit permanent shift is 1. In comparison to less parsimonious models, parametric restrictions are not rejected, and outof-sample forecasts are improved. The theory also yields implications for the welfare cost of in‡ation vastly di¤erent from those of standard shopping time models. JEL: E41 Thanks are due particularly to Joe Haslag, Kim Huynh, and Mohitosh Kejriwal for thoughtful discussions; and to participants in seminars at Purdue University and the 2009 Midwest Macroeconomics Meetings.