Notes on Money and Business Cycles

These notes are concerned with one answer to a fundamental question in macroeconomics: What causes the recurrent ups and downs we call the business cycle? For years, based largely on the work of Friedman-Schwartz (A Monetary History of the United States), the emphasis in macroeconomics was on monetary theories of economic fluctuations. The Great Depression in the United States was explained by the inadequate response by the monetary authorities to prevailing conditions. Earlier downturns in the economy could be traced to monetary instability, including bank runs. Furthermore, looking at the size of movements in output and employment, one needs to think of fairly large exogenous shocks which are able to produce these large movements. One natural place to look is at monetary aggregates. But, this view has been challenged by theory and evidence. On the theory side there are two issues: (i) generating a demand for money and (ii) overcoming the neutrality of money. These themes will be addressed below. As you may know, the basic Arrow-Debreu general equilibrium model has no demand for money. We can generate a demand for money through the overlapping generations structure. So we will stick with that modeling approach. The alternatives seem quite arbitrary ($ in utility functions, cash-in-advance constraints, etc.). The main drawback of the overlapping generations model is that it has difficulty sustaining a demand for money when there are other assets in the economy. That is, it is not a good model of the transactions role of money. The second question on the effects of variations in the money supply is tough too. There is this wonderful thing called the ”neutrality of money” which essentially states that the amount of money in the economy and the real decisions of individuals are totally independent. According to this view, variations in the money supply cause all prices in the economy to move together and so that no relative prices are altered. As a consequence, changes in the money supply have no real effects. This 1There are many empirical papers trying to find evidence that money causes output. The results from these