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,SUPPLY SIDE EFFECTS OF nONETARY POLICY

SYED FAKHRE MAHMUD. B.Sc.(Hons.l. M.A. M.A .

A Thesis

Submitted to the School of Graduate Studies

in Partial Fulfilment of the Requirements

for the Degree

Doctor of Philosphy

© McMaster University

January 1986

f

"-~SUPPLY SIDE EFFECTS OF ~OMETARY POLICY

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DOCTOR OF PHILOSOPHY (1986)[ECONOMICS)

- McMASTER UNIVERSITYHamilton. Ontario

TITLE: Suppry Side Effects of Monetary PoliCY

AUTHOR: Syed Fafhre Mahmud.

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,B. Sc. (Hons.">M.A.M.A.

(Karachi University)(Karachi University)(McMaster~University)

, ,.~...

NuMl!lER OF PAGES: xiii. 156 .:,{I

SUPERVISORY COMMITTEE:

••

Professor William M. Scart~(Chairman)

Professor A. Leslie"RobbProfessor Lonnie J. Magee

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********** ...TO THE MEMORY OF

MY LATE MOTHER••****************

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for factors. One set of studies involves the simultaneous

of empirical work concerning firms' demands

rOO'b'~

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is to

ABSTRACT

----purpose or this" thesisThe primary

two branches

. y

es~mation of money, .labour.and capital demand functions,

whe'::''} the focus is on the '~role of mOT\ey as a f~r-·...-

investment function, together with other factor demand, ,: \. ,functions. Writers in this area typt~lY exclude money as

..! ( •.. ;t-

factor in·the production process-, though we wish to

The

and adjuatment costs ·for capital are ignored.'., 0..

production,

. 0oth~ set of studies involves estimation of an /

~

overcome that omission in this thesis ••

We also study the possible supply side effects of

monetary policy that arise because of the role of money as

a factor of production and deduce macroeconomic policy

implications.

Our empirical werk is divided into three stages.

In each stage we assume that firms minimize the cost of

producing a given level of output subject to a production

function that includes real money balances as· a factor

input. In the first stage we estimate a fUll'~quilibrium

iv

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model in which firms can

without any lags and there

\adjust their capital sto~s

are no costs associated with

the adjustment of these capital stocks. In the second

----stage of estimation we introduce the fixity of capital

stocks in the short-run into the firms' optimization

problem. In ·this temporary equilibrium model, costs of

adjustment. of capital are not assumed. Finally, we

estimate a dynamic model of the firm" based on the,

assumpt~on of non-linear internal costs of adjustment for

capital. The three empirical models are estimated at the,;t. .,

aggregate level for non-financial corporati~s in the

United States.

On statistical grounds. the 'full equilibrium model

did not fit the data well. The own price elasticity of

real money balances was not significantly different from

zero. In the other two models, where capitql is fixed in

•

the short-run, all the own price elasticities are

','significantl~ different from zero and have negative signs.

Furthermore, in the full equilibrium model,

" autocorrelation seemed to be present ~ven after making

a first order correction. for the errors.

." The temporary equilibrium

v

model was also

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statistically rejected, conditional on the particular

functional form of the cost function employed in the

dynamic model. Ve conclude that the dynamic specification

is most appropriate in this context. ,...

The price elasticities' varied substantially acro~s

the different models.,

elasticity of

The cost minimizing inter~rate

labour demand was significantly 'different

from zero and netative•

in sign in the dynamic model.

However, the, implied profit maximizing interest rate

elasticity of labour"-demand was not stat}sticallY

the prod~tion process

ofestimates

were contaminated

ear),ierthatsuggestsThis"" .i.!.......;

money's role in

significant.

by the restriction that the.e were no costs of adjustment •

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-AC~OVLEDGEKENTS

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Allahumman

}/"""'

Laka al-hamd ~a laka al-shukr

It is a great pleasure in acknowledging the help

and guidance I have receive~~ Professor ~illiam M.

Search, my

conunents on

supervisor. He has

the entire study and

provided construc~ive

~gave eneouragement a€

• each and every stage of it. The time'I have spent with him,has left a pleasant and invalu~Dle impr~ssion on me •..

I would also like to express my gratitude to the

other members of my committee, Professors A. Leslie Robb

and Lonnie J. Magee, who ~ave numerous useful suggestions.

Professor A. Leslie Robb made a number of useful comments

on the model specification and gave many helpful

suggestions on the empirical ~ssues.

I have also had some useful discussions with Mr.

Eataz Ahmed on the econometric issues.~.. ' .

I also sincerely appreciate the help of Dr."Z:

Alavi in providing the word processing racili~ies.

I a~ deeply obliged for the patience and support

of my wife, Naeem, during the long period of this study.

Finally, for any errors, of either omission or

commission, I" alone am responsible.

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Table of Contents • Page

AbstractAcknowledgementsList of TablesList of Figures

ivviixixiii

The Structure of Production 47

Factor Demand Elasticities 47

Conc~uding Remarks 36

A Cost Minimization Model With No 0 42Adjustment Costs

30

26

22

5

9

19

1

19

12

Emp~rical Studies of Firms' Demandfor Money

Model B: A Money Requirement Function

Model A: Production Function Model

Model C: The Transaction Demand Model

Empirical Models Based On Cost Minimizing 41Behaviour, With No Cost of Adjustment

Major Theoretical Approaches to theAnalysis of,Demand for Money by Firms

Outline of the Empirical Work

Review of the L~rature on Demand for 16Money by Firms

Structure of Dissertation

Introduction

Macroeconomic Implications

Chapter l.

1.1

1.2

1.3

Chapter 2

2.1

2."1.1

2.1. 2,2.1. 3

2.2

2.3

Chapter 3

3.1

3.2

3.2.1

viii

,3.2.2

3.2.3

3.3

3.3.1

3.3.2

3.3.3

3.4

Chapter 4

4.1

4-.2

4.2.1

4.3

4.3.1

4.3.2

4.4

Chapter 5.

5.1

5.2

5.2.1

Variable Output or Profit MaximizingEias ti ~.1t i es

Separability of Factors in Production

Data and Estimation of Model

Data

Estimation Procedures

Discussion of Results

Concluding Remarks

Empirical Model Based on Cost MinimizingBehaviour with Capital Fixed in Short-Run

A Cost Minimization Model with TemporaryEquilibrium

The Struc~re of Production

Factor Demand E~asticities

Estimation of Model

Estimation Procedure

Discussion of Results

Concluding Remarks

Empirical Mo~el~~ed on Cost MinimizingBehaviour With Costs of Adjustment forCapital

Review of Adjustment Cost Literature

A Cost Minimization Model With Costsof Adjustment

Empirical Model Yor Real Money BalancesWith Internal Co~t of Adjustment forCapital ~

ix

49

52

55

55

59

62

74

76

78

84

84

85

85

86

98

103

110

5.3

5.3.1

5.3.2

5.4

5.4.1

5.4.2

5.5

Chapter 6

APPENDIX A

BIBLIOGRAPHY

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The Structure of Production

Role of Costs of Adjustment

Factor Demand Elasticities

Variable Output or Profit Maxi.mizingElasticities

Estimation of Model

Estimation Procedure

Discussion of the Results

Concluding Remarks

ConcluGlons ~nd Suggestions for FurtherWork

LIST OF DATA

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120

121

122

122

127

136

140

148

150

TABLE

3.1

3.2,,

3.3

3.4

3.5

3.6

3.7

4.1

4.2

4.3

4.4

4.5

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LIST OF TABLES

Conditions for Separability

Results of the F~ll Equilibrium Model(No Correction for Serial Correlation)

Results of the Full Equilibrium Model ­(After Correcting for Serial Correlation)

Estimated p's.

Separability of Factor Inputs

Factor Price Elasticities

Confidence Intervals for Own PriceElasticities(Fu11 Equilibrium'Model)

Estimated Parameters of the TemporaryEquilibrium 'Model( No correction forSerial-Correlation)

Estimated Parameters of the TemporaryEquilibrium Model(After Correcting forSerial Correlation)

Own Price Elasticities

Confidence Intervals for Own priceElasticities(Temporary Equilibrium Model)

Cross Price Elasticities

PAGE

54

63

67

68

70

72

72

88

89

91

91

93

5.1

5.2

5.3

5.4

Results of the Dynamic Model

Estimated p's and Durbin-~atson Statistic

"Estimated Desired Capital Stocks and 8

Own P~ice Elasticities

xi

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126

129

132

TABLE

5.5

5.6

5.7

5.8

A .1

A.2

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Confidence Intervals for Own PriceElasticities(Dynamic Model)

Cross Price Elasticities

Effects of Change~ in Interest Rate onLabour Demand

Confidence Intervals for Cross PriceElasticities(Dynamic Model)

Data on Prices'

Data on Factor Inputs and Output

xii

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132

134

137

137

148

149

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FIGURE

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LIST OF FIGURES

Aggregate Demand and Aggregate Supply Analysis

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Page

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CHAPTER I

INTRODUCTION

The importance of money in aggregate economic

activity is universally recognized. In recent yea~s,

several studies have been undertaken to increase our

understanding of the differences in motives for holding

cash balances between individuals and business firms l • The

results of these empirical studies indicate that real

money balances do play a significant role in firms'

production processes and ehey should be considered as a

factor input in the production function. These studies

typically estimate money, labour and capital dem,and

functions simultaneously and assume ~hat capital stocks

can be adjusted costlessly and instantaneously. However,~-

recent studies on the role of energy in production have

questioned the assumption of instantaneous adjustment of

capital stock and have successfully developeq,empirical-'

models that explicitly incorporate the notion of the cost

of adjustment of capital in the optimization framework of/

firms 2 • These studies have made clear that the assumption

of fully adj~stable capital stocks does contaminate the

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results. Writers in this' area, however, exclude mohey as a

factor in.the production process •.,....,

The primary aim of the empirical work in ,this

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thesis is to re-examine the role of real money balances in

Ia production framework that does not assume instantaneous

aiju~tmen; of capital stocks.

The limitations of the· existing empirical work are

not the only motivations for our study. A secondary issue',

on which we like to focus on.. is the macrbeconomic

implications of introducing real money ba~ances into the

production function. Standard macroeconomics ignores the

role of real money balances in the production function.

Therefore~ the aggregate demand _ function for labour is

independent of the rate of interest in the short-run and

there are no supply side effects of, changes in the rate of

interest on _the level of employment. Inclusion of real

money balances in . the production function as .,." factorI

input, on the other hand, provides potential for these

supply side effects on~the employment levels.--?' .-~

Consider the standard agBregate supply (AS) and

'demand (AD) functions in,-

Figure 1. In this model we also

assume that real money balances enter into the aggregate

production <:function as a -factor input. A contractio~ary

monetary policy, aiming to reduce inflation in the

short-run, leads to an-- increase in the rate of interest.

The

,

increase in the interest rate shifts the aggrei,ate

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FIGURE 1

AG&REGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS

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LEVEL

I •

3

VI I

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y/;1. 'I'

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A.D, •

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OUTPUT

,

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demand function from ADo to AD l ,. However, what is

-. generally unrecOgnfzed is that the aggregate supply

function may also ';1lhi ft from ASo to AS l , if labour and, /"

real money balances are complements in the production

process. ~ith supply side effects. as shown,' the price

level' goes down from Po to P l rather than to P 2 if the

aggregate supply function did not shi'ft. Not only is the~

decrease in price smaller in the face 6f this sort of

supply shift, the decrease in the level of output and

therefore the level of employment is more with the'shift

in the aggregate supply function. ~learly the shift in the

aggregate supply function offsets the aim of the policy.

In fact, if the shift in the ~ggregate supply function

outweighs the shift in the aggregate demand function then

we would find that the policy actually resulted both in an

increase in' the p;ice level and unemployment. It is these

possibilities that further motivate the

that follows.

need for the work

There are two main tasks -that we undertake in this

chapter. First. we estimate th~ size of the supply side

effe~ts of changes in the rate of interest on employment.

These macroeconomic implications are based on estimates of

production function parameters that follow from the

existing empirical studies of the demand for money based

on the production function approach ..

- Second, we argue that there is a need to

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re-examine the role of real money balances in the firms'. ,.optimization problem because the empirical studies that

have been conduc.ted so far in this area assume

instantaneous adjustment of capital stocks.

1.1 MACROECONOMIC IMPLICATIONS

In this section we introduce a supply-determined

macro model with real wage rigidity3. We demonstrate the\

significance o"f the sup"ply-side ·effects :to changes in the

rate of interest on the level of" employment by comparing

".

the interest rate elasticities of employment in two

models: one in which output is supply-determined and one

in which output is demand determined.

Without allowing any role for money in the

produc~ion process. the interest elasticity of employment

is zero, when real wage rigidi~ is assumed. The aggregate

supply fu~ction is vertical and therefore any shift in the,

aggregate demand function (such as that caused 'by ··a change

in the inter~st rate) does not change the level of output.

However. when real money balances are introduced into the

production function, the demand for labour becomes a

function of the opportunity cost of money. i.e .. the rate

of interest, and the aggregate supply fun~tion shifts with

changes in the rate of interest. The first order

;

conditions for profit maximization (with static expect ions

6

•[Money Demand'3

[Investment Function)

[Production Function)

for the firm) to'gether with t'he production functio,\ are

[Labour Demand][1.1) Fn(N,m,lC) = w

~' [1.2) Fm(N ,m,,<f) = r

[ 1.3) IIIC = B{Fk /(r+6) 1}

[1. 4) Y = FeN .IC,m)= ANQ K8mY"

where Fn and F are the marginal products of labour(N) andm '

realc

money balances(m) respectively. w and r are real

wages and the rate of interest respectively. 6 is the rate

depreciation. [1.3) is an investment(I) function based on

the assumption of costs of adjustment for capital,(K).

where B is the reciprocal

adJustment 4 .

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of the coefficient of costs of

Since capital is fixed in the short-run. and real

wages are fixed by the assumed labour suppl~ behaviour,

and since we take the interest rate as the exogenous

instrument of monetary policy for this demonstration of

policy relevance, [1.1] and ~1.2] can be solved for the

~evel 'of employmen~ and money supply. The level of

investment in [1.3) can be solved recursively. Using the

particular functional form of the production function ,.specified in [1.4). we can calculate the interest

elasticity of employment by differentiating [1.1) and

[1.2) simultaneously5, .~

[1. 5) (dN/N)/(dr/r) = -y/(l-Q-y).

•,~.

• Several empirical studies attempt to measure the

productivity of c'ash balances as. a factor input in the