Optimal Monetary and Fiscal Policies in Cash-in-Advance Economies with Monopolistic Competition

Abstract

For an overlapping-generations model with 2-period life-cycles for individuals and monopolistic competition in the goods markets, Chang (1989) demonstrates that deflationary monetary policy supported by lump-sum taxation is able to implement a Pareto-optimal allocation as stationary perfect-foresight equilibrium. He himself raises the question whether his “conclusions are robust to other assumptions about the nature of competition or the monetary sector” (p. 20). In Chang’s model fiat money is valued because it is the only store of value available to young individuals. In the present paper the positive value of money in equilibrium is secured by a cash-in-advance constraint on individual transactions. Furthersmore, the life-cycle OLG-structure is replaced by what Blanchard and Fischer (1989, pp. 115–122) call a “model of perpetual youth”, i.e. overlapping cohorts of individuals with infinite planning horizons but constant and identical finite life expectancies. In other respects this model does not differ significantly from Chang’s. There is also neither storage nor capital accumulation, and, in particular, monopolistic competition is likewise introduced via the now standard simple assumption of commodity heterogeneity with constant elasticity of substitution in consumption as discussed, e.g., by Blanchard and Fischer (1989, pp. 376–381). It turns out, however, that due to the role of money as means of payment imposed by the cash-in-advance constraint, Chang’S conclusions have to be significantly qualified: Monetary policy and lump-sum taxes alone cannot support a stationary perfect-foresight equilibrium that is Pareto-optimal.