Summary of the literature: theoretical aspects

Abstract

Modern analysis of the long run interaction of inflation and capital formation begins with Tobin’s seminal contribution in 1965. Presenting a monetary version of Solow’s growth model, Tobin (1965) considers a closed economy in which ‘outside money’ competes with real capital in the portfolios of agents. As a matter of definition, outside money is the part of the money stock which is issued by the government. Correspondingly, it represents, according to Tobin (1965), “…neither a commodity produced by the economy nor the debts of private individuals or institutions.”¹ Moreover, “…its own-yield (i.e. the amount of the asset that is earned by holding a unit of the asset a given period of time) is arbitrarily fixed by the government. This may, of course, be zero but it is not necessarily so.”²

Article Footnote

¹Tobin (1965), p. 676. The stock of outside money represents liabilities of the central bank. In other words, it constitutes the monetary base of the overall money stock which can be directly controlled by the monetary authority through outright purchases of assets (such as open market purchases of government bonds or purchases of foreign reserves), reverse transactions with repurchase agreements (such as discount window lending) or, if the monetary authority lacks independence, through unbacked injections of money on behalf of the fiscal agent. In contrast, the stock of inside money consists of all private credit arrangements with varying degrees of liquidity and transferability. Using the standard classification of monetary aggregates, outside money is given by the aggregate Mo which consists of currency holdings of the private sector and the net reserves position of financial intermediaries. Broader measures of the money stock such as M1- M3 are obtained by adding inside money components depending on their degree of liquidity. Note that in a closed economy, for the private sector as a whole, inside money does not represent net wealth.

²Tobin (1965), p. 676. In fact, well in accordance with everyday experience, we assume throughout our analysis that zero nominal interest is paid on outside money.