3 - Credit policy and the price level in a cash-in-advance economy

Summary

This chapter considers the determination of interest rates and prices in a simple intertemporal general equilibrium framework. The resulting theory is used to examine the short- and long-run consequences of a policy of credit expansion through inside money creation.

The intertemporal equilibrium framework used here combines the demographic structure of an overlapping-generations model with a cash-in-advance constraint. The cash-in-advance constraint allows valued fiat money to co-exist in equilibrium with debt, yielding a positive nominal interest rate. The specific structure considered here allows a traditional account of the “liquidity effect” of open market operations upon the nominal interest rate in the short run to be rigorously connected with a longrun equilibrium analysis. The absence of such a theoretical connection has led to a certain amount of confusion in the literature about whether or not the liquidity effect of credit expansion, generally agreed to exist in the short run, can be maintained in the long run. It is shown that for the model economy considered here, open market operations can keep both the nominal and the real rate of interest low forever; and, whereas a lower interest rate is achieved in the short run only at the cost of a rise in the price level, in the long run different interest rates may be equally compatible with price-level stability.