Neoclassical economists, who argue that money is `neutral' in that only unanticipated money supply changes induce output and employment to deviate from their natural rates, and adherents to Tobin's view that even anticipated increases in nominal monetary growth may boost the natural level of output both assume that the money supply can affect economic growth only in the short run. New `endogenous growth' theories following Romer and Lucas assume that the `capital stock', broadly defined to include stocks of physical assets, ideas or knowledge of all firms and infrastructural public goods, may be augmented through investment. Production externalities from spillovers of learning by doing, R&D and infrastructural public goods may therefore affect capital's marginal productivity and hence long-run economic growth; but these theories assume infinitely-lived households (or dynasties with fully operative intergenerational bequest motives) and therefore do allow neither fiscal nor and monetary policies to influence long-run economic growth.

In recent work Research Fellows George Alogoskoufis and Frederick van der Ploeg have shown that when such models are extended to include non-interconnected overlapping generations demand management polices may have permanent real effects. In Discussion Paper No. 532, they assess the effects of monetary growth on inflation and economic growth. For a model with no operational bequest motive, output proportional to both the firm's and aggregate capital stock, and money demand derived from a utility function with real money balances, they show that Ricardian debt neutrality holds when there is no new entry of non-interconnected generations. Monetary growth and public consumption and debt therefore affect neither real growth nor inflation; money is superneutral and government consumption fully crowds out private consumption.

With taxes as the residual mode of government finance, a positive birth rate raises the share of private consumption in national income, reduces real growth and increases inflation. Monetary growth is no longer neutral: balanced-budget increases in government consumption cut real growth and boost inflation. With monetary growth as the residual mode of government finance, however, postponing taxes reduces growth and increases inflation. Bond-financed changes in government consumption reduce growth prospects more than tax-financed changes, while money- financed changes reduce growth least.

Alogoskoufis and van der Ploeg also suggest that the adjustment costs associated with investment may account for the discrepancy between most theories of growth, which predict a positive correlation between real growth and real interest rates, and the large body of empirical work that has failed to detect any such correlation: shifts in government debt and consumption or monetary growth cause the predicted correlation to disappear.

In Discussion Paper No. 533, Alogoskoufis and van der Ploeg use a two-country, endogenous growth, overlapping generations model to investigate the relation between budgetary policies, economic growth, current account imbalances, real interest rates and the stock market valuation of capital, in order to account for the significant average rise in the major industrial economies' ratios of public debt to GDP in the 1980s. Assuming that capital is mobile and that countries differ principally in their productive efficiency and fiscal policies, they focus on the international spillovers from capital accumulation.

If capital is perfectly mobile, its marginal productivity, real interest rates and hence endogenous growth must be the same in all countries. Relative output levels and capital stocks are determined by exogenous differences in productive efficiency. Savings and growth rates are lower than in a comparable representative household model, in which all population growth occurs within the representative household and there is no entry of non-interconnected generations. Growth is lower in the overlapping generations model: households that are not concerned about the welfare of yet unborn agents save less. Growth also falls with increases in either the average ratio of public debt to GDP or the average share of public consumption in GDP, which both reduce global savings and hence capital accumulation.

Alogoskoufis and van der Ploeg also show that a relative increase in the public debt/GDP ratio or the share of public consumption in GDP leads to a fall in the affected country's total savings rate, which is greater on impact than in the steady state. The economy then follows an adjustment path along which it experiences higher current account deficits and a rising ratio of external debt to GDP. If both countries face the same adjustment costs of investment, their endogenous growth rates are again equal: equilibrium global growth and world interest rates are both lower than they would be without adjustment costs. Higher average public debt/GDP ratios raise the world real interest rate and reduce both the global growth rate and the stock market valuation of capital. If the countries' adjustment costs differ, the economy with the greater adjustment costs will grow more slowly.

Alogoskoufis and van der Ploeg conclude that their two-country overlapping generations model of endogenous growth can account for the events of the 1980s in terms of the major industrial countries' fiscal policies. The fall in the average growth rate and the increase in world real interest rates may result from the average rise in public debt/GDP ratios. The higher current account deficits of countries such as the US may reflect the relative rise of their public deficits and debt. This result also obtains in exogenous growth, overlapping generations models, but the latter cannot account for the growth effects of budgetary policies as described here.

Money and Growth Revisited
Debts, Deficits and Growth in Interdependent Economies
George Alogoskoufis and Frederick van der Ploeg

Discussion Paper Nos. 532-3, March and April 1991 (IM)