Adaptive learning and monetary exchange

• Published in: Journal of economic dynamics & control 2015-09, Vol.58, p.1-18
• Main Author: Baranowski, Ryan
• Format: Article
• Language: English
• Subjects: Adaptive learning; Economic theory; Expectations; Inflation; Learning; Monetary theory; Money; Money supply; Output; Phillips curve; Rational expectations; Search; Social costs; Studies
• ISSN: 0165-1889; 1879-1743
• DOI: 10.1016/j.jedc.2015.05.018

This paper investigates three classic questions in monetary theory: How can an intrinsically worthless asset, such as fiat money, maintain value as a medium of exchange? What are the short-run and long-run effects of a change in the money supply? What is the social cost of inflation? I answer these questions using a microfounded model of monetary exchange that replaces the rational expectations assumption with an adaptive learning rule. First, I show that monetary exchange is a robust arrangement in the sense that agents are able to learn the stationary monetary equilibrium while the non-monetary equilibrium is unstable under learning. Second, an unanticipated monetary injection has real effects in the short-run because learning the value of money takes time. In the long run, agents successfully learn the value of money, hence money is neutral. Third, under a constant money growth policy, an increase in the growth rate of money increases output in the short-run producing a short-run Phillips curve. A ten percent increase in the money growth rate has a social cost of 0.41 percent of output per year. Alternatively, a ten percent decrease in the money growth rate has a social benefit of 0.37 percent of output per year.