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

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1 !.-' "",...,., 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

2 f "-~ SUPPLY SIDE EFFECTS OF ~OMETARY POLICY

3 / -.' DOCTOR OF PHILOSOPHY (1986) - McMASTER UNIVERSITY [ECONOMICS) Hamilton. Ontario TITLE: AUTHOR: Suppry Side Effects of Monetary PoliCY Syed Fafhre Mahmud..., B. Sc. (Hons."> M.A. M.A. (Karachi University) (Karachi University) (McMaster~University) SUPERVISORY COMMITTEE:.~...,, NuMl!lER OF PAGES: xiii :,{ I Professor William M. Professor A. Leslie"Robb Professor Lonnie J. Magee Scart~(Chairman) -'.,. '..'.! / ii ~.

4 /.... : **********... TO THE MEMORY OF MY LATE MOTHER ****************, \...,.. ~ iii

5 ABSTRACT r. y two branches The primary for factors. One set purpose ---- or this" thesis of empirical work OO'b'~ is to concerning firms' demands of studies involves the simultaneous es~mation of money,.labour.and capital demand functions, whe'::''} the focus is on the '~role of mot\ey as a f~r-...- i \ '. 0., production, and adjuatment costs for capital are ignored.. 0 The oth~ set of studies involves estimation of an / investment function, together with other factor demand,,: \., functions. Writers in this area typt~ly exclude money as..! (.. ;tfactor in the production process-, though we wish to ~ 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

6 .. -'..~ model in which firms can adjust their capital sto~s \ without any lags and there 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 model was also v

7 -, t " 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. The cost minimizing inter~rate elasticity of 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 significant..; money's role in This "".i.!... suggests that the prod~tion process ear),ier estimates of were contaminated by the restriction that the.e were no costs of adjustment.... '. vi.-

8 .., ) / \ ; ~ - AC~OVLEDGEKENTS 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. vii

9 '0 "0 Abstract Acknowledgements List of Tables List of Figures Table of Contents Page iv vii xi xiii Chapter l Introduction Macroeconomic Implications Outline of the Empirical Work Structure of Dissertation Chapter 2 Review of the L~rature on Demand for 16 Money by Firms 2.1 Major Theoretical Approaches to the Analysis of,demand for Money by Firms 19 2."1.1 Model A: Production Function Model , Model B: Model C: A Money Requirement Function The Transaction Demand Model Emp~rical Studies of Firms' Demand for Money Conc~uding Remarks 36 Chapter 3 Empirical Models Based On Cost Minimizing 41 Behaviour, With No Cost of Adjustment 3.1 A Cost Minimization Model With No 0 Adjustment Costs The Structure of Production 47 Factor Demand Elasticities 47 viii

10 , Variable Output or Profit Maximizing Eiasti ~.1t i es Separability of Factors in Production Data and Estimation of Model Data Estimation Procedures Discussion of Results Concluding Remarks 74 Chapter 4 Empirical Model Based on Cost Minimizing Behaviour with Capital Fixed in Short-Run A Cost Minimization Model with Temporary Equilibrium The Struc~re of Production Factor Demand E~asticities Estimation of Model Estimation Procedure Discussion of Results Concluding Remarks Chapter 5. Empirical Mo~el~~ed on Cost Minimizing Behaviour With Costs of Adjustment for Capital 5.1 Review of Adjustment Cost Literature A Cost Minimization Model With Costs of Adjustment Empirical Model Yor Real Money Balances With Internal Co~t of Adjustment for Capital ~ 110 ix

11 The Structure of Production Role of Costs of Adjustment Factor Demand Elasticities Variable Output or Profit Maxi.mizing Elasticities Estimation of Model Estimation Procedure Discussion of the Results Concluding Remarks Chapter 6 ConcluGlons ~nd Work Suggestions for Further 140 APPENDIX A LIST OF DATA 148 BIBLIOGRAPHY 150 x

12 ; LIST OF TABLES TABLE ,, 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 Price Elasticities(Fu11 Equilibrium'Model) Estimated Parameters of the Temporary Equilibrium 'Model( No correction for Serial-Correlation) Estimated Parameters of the Temporary Equilibrium Model(After Correcting for Serial Correlation) PAGE Own Price Elasticities Confidence Intervals for Own price Elasticities(Temporary Equilibrium Model) Cross Price Elasticities Results of the Dynamic Model Estimated p's and Durbin-~atson Statistic Estimated Desired Capital Stocks and 8" Own P~ice Elasticities ' xi

13 ,.,,- TABLE 5.5 Confidence Intervals for Own Elasticities(Dynamic Model) Price Cross Price Elasticities Effects of Change~ in Interest Rate on Labour Demand Confidence Intervals for Cross Price Elasticities(Dynamic Model) A.1 A.2 Data on Prices' Data on Factor Inputs and Output , xii

14 . / LIST OF FIGURES FIGURE Page. 1 Aggregate Demand and Aggregate Supply Analysis 3 / ( xiii

15 / 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

16 - '. results. Writers in this' area, however, exclude mohey as a factor in.the production process.,..., The primary aim of the empirical work in,this thesis is to re-examine the role of real money balances in.,~ I a 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.,." factor I 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 The, increase in the rate of interest. increase in the interest rate shifts the aggrei,ate

17 .~ 3 FIGURE 1 AG&REGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS.' LEVEL..,,. I A.D,.. V I I y /;1. 'I' '0 / /' OUTPUT /

18 , 4 demand function from ADo to AD l,. However, what is -. generally unrecognfzed is that the aggregate supply function may also ';1lhift from AS o 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 need for the work that follows. 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

19 ... 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 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 ;

20 6 for the firm) to'gether with t'he production functio,\are [1.1) Fn(N,m,lC) = w ~' [1.2) Fm(N,m,,<f) = r [ 1.3) IIIC = B{F /(r+6) k 1} [1. 4) Y = FeN.IC,m)= AN Q K 8 m Y " [Labour Demand] [Money Demand'3 [Investment Function) [Production Function) where F n and F m are ' the marginal products of labour(n) and c real 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. ", 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

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Voluntary Disclosure of Intangibles by Capital-Raising Companies in Australia

Voluntary Disclosure of Intangibles by Capital-Raising Companies in Australia by Hazianti Abdul Halim B. Acc (Hons.), Universiti Teknologi MARA, Malaysia, 2000 M. Acc, Universiti Teknologi MARA, Malaysia,