Journal of Monetary Economics 16 (1985) 19-44.

North-Holland

THE BACKING OF GOVEBNMENT

MONETARISM
S. Rao AIYAGARI
Universi[y

of Wisconsin,

BONDS AND

and Mark GERTLER*

Madison,

WI 53706,

USA

This paper examines the implications of the fiscal backing of government bonds for the effects of
conventional macroeconomic policies and, in particular, for certain monetarist propositions. It
shows that the validity of some basic monetarist hypotheses requires a considerable degree of
accommodation by the fiscal authority, relative to the central bank. Otherwise, government bonds
may matter in a manner as described in the traditional literature [e.g., Patinkin (1965). Mundell
(1971)], though some differences arise. Of perhaps independent interest, the framework developed
in the analysis is an intertemporal general equilibrium model with all the descriptive features of the
conventional flexible price IS/LM model.

1. Introduction
This paper examines the link between the backing of government bonds and
the effects of certain conventional macroeconomic policies. The term backing
refers to how the government plans to meet the obligation on its interest
bearing debt; it reflects the intertemporal relationship between monetary and
fiscal policy. A useful way to structure the analysis is to focus on the
implications for some hypotheses normally associated with monetarism.
The propositions we consider monetarist are as follows: (i) money is the only
government liability which affects economic variables, (ii) it is unimportant to
distinguish whether the money supply is adjusted by monetary or fiscal policy,
(iii) the price level varies proportionately with the money supply (the quantity
theory), (iv) the nominal interest rate covaries exactly with the anticipated
money growth rate (the Fisherian theory). Since we do not mean to imply that
anyone believes propositions (i)-(iv) hold under all circumstances, we conduct
the analysis within an environment typically viewed as favorable to monetarism,
a neoclassical intertemporal general equilibrium model with rational expectations. In particular, the model is free of both the wage/price rigidities and the
informational asymmetries which provide the usual explanations for why the
quantity and Fisherian theories may not be valid in the short run.
We instead address the prior issues of, first, defining within a frictionless
setting the explicit circumstances under which monetarist principles hold and,
*We would like to thank Robert King for helpful comments, and the National
Foundation for financial support. Any errors are ours.
0304-3923/85/$3.3001985,

Elsevier Science Publishers B.V. (North-Holland)

Science

second, analyzing the implications for behavior when these conditions are not
met. We proceed to ascertain whether and how government bonds matter, and
to examine the short-run relationships between the money supply and the price
level and between the money growth rate and the nominal interest rate. We
also investigate whether it matters if it is monetary or fiscal policy which alters
the money supply.
As suggested, the results depend critically on the backing of government
bonds. Following Sargent (1982a), we make the distinction between polar
Ricardian and non-Ricardian fiscal regimes. In the former, the fiscal authority
provides full backing for its interest bearing debt; at each point in time it
commits to levying a stream of future direct taxes with a present discounted
value matching the current value of its bond obligation. In this regime, new
bond issues imply additional taxes in the future. On the other hand, the fiscal
authority does not finance the debt in the polar non-Ricardian regime. In this
case, the debt is implicitly backed by money creation. An adjustment in the
current stock of bonds thus signals a change in, future money growth, as
opposed to future direct taxes. In between the polar cases lies a continuum of
fiscal regimes which vary according to the fraction of the interest bearing debt
which is backed by taxes.
In practice, the distinction between the various regimes reflects the extent to
which fiscal policy accommodates monetary policy, and vice-versa. In the polar
Ricardian case, the fiscal authority will fully accommodate a central bank open
market sale by financing the new debt with future tax levies; however, the
central bank will not respond to new bond issues generated by an increase in
the deficit. The reverse holds in the polar non-Ricardian regime. The central
bank will fully accommodate a fiscal deficit by financing the new debt with
current and future money creation; on the other hand, the fiscal authority is
insensitive to monetary policy. In between the two polar cases, monetary and
fiscal policies accommodate each other to varying degrees. The particular
regime which prevails matters to the economy, since rational agents discount
future direct tax levies differently than future money creation.
We summarize the main results as follows:
(1) The four monetarist propositions can be satisfied only in the polar
Ricardian regime. We show that the irrelevance of government bonds requires
that the bonds matter neither to private budget constraints nor to the government budget constraint, and that these conditions can be met only in the polar
Ricardian case. For the Fisherian theory to hold, there is the additional
Note that according
to Sargents definition.
the term Ricardian
refers to how govcmmcnt
bonds
are.backed,
and not to whether
the Ricardian
Equivalence
Theorem
regarding
the irrclcvancc
of
government
bonds holds. In this respect, it is possible for bonds to matter in the polar Ricardian
regime, if the associated
tax collections
aflect private budget constraints.

S. R. Aiyagari

and M. Gertler,

The backing

of government

bonds

and monetarism

21

requirement that fiscal policy compensate for the Mundell (1971) and Tobin
(1965) effect.
(2) Government bonds matter to nominal variables in the polar nonRicardian case, and hence the monetarist propositions fail. The irrelevance
proposition does not hold since the bonds matter to the government budget
constraint; they affect the future stream of money growth. We show, in
contrast to the quantity and Fisherian theories, that the price level is proportionate to the total supply of government liabilities and that the nominal
interest rate depends on the composition. Further, the manner in which the
money supply changes is critical. A rise in the money supply due to a
temporary open market operation wiIl lower the nominal interest rate, but will
not affect the price level. If the rise is instead due to a temporary fiscal policy
shock, the price level will adjust proportionately.
(3) The price level, the inflation rate and the nominal interest rate are higher
in the non-Ricardian than in the Ricardian regime. As the regime converges to
the polar non-Ricardian case, these variables rise continuously due to the
increasing influence of government bonds. The results correspond to the
analysis of the inflationary experiences of several post-World War I European
economies by Sargent (1982b), who stresses the importance of the backing of
government liabilities.
(4) Observed long-run correlations between money and prices and between
money growth and nominal interest rates need nor represent evidence of a
monetarist/Ricardian
regime. These rough correlations are also likely to be
observed in a non-Ricardian regime, even though it is the complete supply of
government liabilities which is actually governing nominal variables. The
reason for this is that stability considerations will force the central bank on
average to keep the growth of the money supply in line with increases in the
total supply of government liabilities. In addition, it is possible to explain
another stylized observation within the non-Ricardian setting, namely an
inverse relationship between temporary changes in money growth and nominal
interest rates. However, a permanent increase in money growth will eventually
lead to a matching rise in the nominal interest rate.
Our analysis parallels the traditional discussion [e.g., Patinkin (1965),
Mundell (1971)] on the effects of government bonds in a classical macroeconomic framework. In this literature, government bonds introduce wealth
effects, except in the limiting case where the private sector perceives an exact
offsetting future liability. Further, the basic monetarist principles emerge only
in this limiting case. Otherwise, the price level is governed by the total supply
of government liabilities, and the interest rate depends on the composition, as
in our analysis. In the traditional literature, however, private agents capitalization of government bonds is arbitrarily determined. We differ by studying the
problem within an explicit intertemporal optimizing framework; in particular,

22

S. R. A@aguri

and M. Gertler.

The backing

of governmenr

bonds atrd nlouerarisnl

the private capitalization rule is instead the outcome of a rational calculation,

based on the prevailing fiscal regime. While some of our main conclusions
follow in the spirit of Patinkins and Mundells analysis, there are also some
important differences. Our approach allows us to be explicit about why the
similarities and differences arise.
The rest of the paper is organized as follows. In section 2, we describe the
basic framework, a general equilibrium endowment economy. In section 3, we
describe the Ricardian and non-Ricardian regimes and then derive the results.
We discuss some empirical implications of the analysis in section 4. Section 5
concludes. In the appendices, we describe how our analysis is easily extended
to a production economy and discuss some additional results.

2. The basic framework

The model is a variant of the Diamond (1965) framework, modified to

include money but exclude production. It consists of overlapping generations
of two-period lived agents. We consider a one-good pure exchange economy.
The good is non-storable, and the population is constant. Without loss of
generality, we assume there is one agent born each period. There are accordingly two agents each period, referred to as young and old. There exist three
assets: money, government bonds and a single perfectly divisible equity. The
latter is a claim to a physical asset which is fixed in quantity and forever yields
a constant stream of the consumption good, analogous to Lucas (1978). The
price of the equity serves to define the real rate of interest. Finally there is a
government sector which consumes, levies taxes, and issues fiat money and
bonds.
We use a heterogeneous agent model because it allows us to distinguish the
implications of the prevailing fiscal regime for the government budget constraint versus private budget constraints. This approach will be useful in
comparing our analysis with the traditional literature.

2.1. Consumers

Each young agent receives an endowment of w units of the single non-storable commodity in the first period of life, and nothing in the second. Let
cY(t), c,(t) be consumption at t by the young and the old, respectively, m the
demand for money, b the demand for bonds, u, the real price of the equity at
t, # the fraction of the equity demanded, d, the units of the commodity
yielded by the physical asset at t (i.e., the dividend stream), p, the price level
at I, i, the nominal interest rate at t, and 7J t), rO(t) the taxes at t on the
young and old agent, respectively. The young agent at t faces the utility

S. R. Aiyugari

ad

hf. Gertler,

The backing

of governmenr

bon&

cd

monetarism

23

maximizing problem

(2.1)

subject to
b

cy(t)=wy(r)-;-

c,(t+l)=A+

P r+1

(1 + UP,

-@J,*

~+~(~,+,+v,+,)-~o(~+1),
Pr+1

(2.2)

(2.3)

where b/(1 + i,) is the nominal cost in period t of bonds which pay b dollars
at (r + 1).
E,( .) is the expectation based on information at t, which includes the
realization of all random variables dated t. We allow certain policy instruments to be random, so that we can distinguish between temporary and
permanent changes in policy variables. This approach is necessary in order to
control for the effects of the policy change on beliefs about the future.
The consumers problem differs from the one in the Diamond model,
primarily because fiat money is available. A careful consideration of why
individuals hold fiat money and why the return on government bonds dominates
the return on money, when the two assets have identical pecuniary risks, is
beyond the scope of this paper. We adopt the approach of positing that real
balances enter the utility function to represent the notion that an inventory of
money provides a non-pecuniary return by facilitating transactions. This
method is the most tractable. However, our analysis is amenable to alternative
ways of explaining rate-of-return dominance, such as the legal restrictions
approach [e.g., Bryant and Wallace (1980b)] or the Clower constraint method
[e.g., Lucas (1980)].
The utility function in (2.1) implies that agents are risk-neutral, since
second-period consumption enters linearly. As a result, bonds and equity are
perfect substitutes. The following arbitrage condition holds:

(lfi,)E,(&)=E,(

f+l;v+l).

(2.4)

24

S. R. Aiyagari

and M. Gertler,

The backing

of gooernment

bonds and monetarism

The first-order conditions yield demand functions for real balances and
interest bearing assets:
m
-=
Pf

a+-T,(t)-T,l(t)],

(2.6)

where
1
q=l+ol+py

E,bo(t
()

+ 1))

= Cl+ i,)E,( P,/P,+~

and r;(f) is the present value of the second-period tax liability. The asset
demand functions are homogeneous of degree one in wealth, (w - T,,(I) - $( t )).
The demands for real balances and interest bearing assets depend on the
nominal interest rate, as in conventional formulations.
The old agent at t owns M,-, units of money, II,-, units of nominal bonds
and the equity. He receives the dividend d, on the equity, markets his assets,
pays taxes and consumes.
For analytical convenience, we assume that d, is constant, and equal to d.
2.2. Government

Each period the government consumes the fraction g, of the total endowment. The random variable & is i.i.d. with mean jj. Expenditures are financed
with lump-sum taxes, money, and one-p.eriod discount bonds. M, and B, are
the supplies of money and bonds at the close of period t. The government
budget constraint is, accordingly,
B
~+g,w=Ty(r)+To(f)+
I

w - w-1
p
I

4
(1 + i,)P, .

(2.7)

B,-Jpr is the current real obligation on government bonds. The first two terms
on the right are the tax levies on the young and old, respectively. The third and
fourth represent revenue from money creation and bond sales.
Without loss of generality, assume taxes are levied only to meet the obligation on the debt. Further, let (1 - 8) be the fraction of the obligation which is
backed by direct taxation, where 0 -z 6 < 1. That is, the present value of the
stream of direct tax levies equals (1 - 6) times B,-Jp,. A time-stationary tax
policy which satisfies this property is

~y(~>+~o(~)=(l-~)&p- 4, 0, -p4-J
I I.
I
[

S, R. A iyagari

and h4, Gertler,

The backing

of government

bon&

and monetarism

25

The policy requires that, each period, tax levies equal (1 - S) times the
difference between the present value of the current interest obligation on
the debt and a term which corrects for the adjustment in the value of the
obligation.
To verify our claim regarding the tax policy, let T, be the expected present
discounted value of taxes from t to 00. Then T, must satisfy

~=Ty(f)+TO(t)+

E,(T,+,)
(I+ i,)E,hh,+,)

(2.9)

In view of (2.8), it is clear that

(2.10)
satisfies (2.9). Importantly, eq. (2.8) characterizes how fiscal policy in the form
of taxes adjusts to changing levels of government debt in order to satisfy the
present discounted value property (2.10) at alI dates.
It can be determined that 6 is the fraction of the bond obligation which is
backed by money, as follows. Let G, and A, be the present values of the
streams of government expenditures and of the revenue from money finance,
respectively. Thus,

E,(G,+,)
Gr=gtw+
(~+~,)E,(P,/P,+~)

.A,= 4 - W-1 +
PI

J%Wr+J
(1+ i,)E,WP,+J

(2.11)

(2.12)

It follows from (2.9), (2.11), (2.12) and the government budget constraint (2.7)
that

4-1
-+
PI

G,=e-M,+ T,,

Eq. (2.13) is simply the governments intertemporal - as opposed to current

period - budget constraint. By substituting (2.10) into (2.13) for T,, we obtain
(2.14)

Eq. (2.14) states that current and future money creation backs the fraction 6 of
the current bond obligation, in addition to the present value stream of

26

S. R. Aiyclgori

and M. Gerrler.

The bucking

ojgooertme~~t

bonds

utld nlonerurism

government expenditures. We refer to the case when 6 = 0 as the polar

Ricardian regime. This is the case in which bonds are completely backed by
direct taxes. Correspondingly, 6 = 1 defines the polar non-Ricardian regime
where bonds signify future money creation.
Inserting the tax rule (2.8) into the government budget constraint (2.7)
implies
B

6 25

PI

+ g,w = Mt-w-1
PI

+a

4
0 + 4) Pr .

(2.15)

Note that, in the polar Ricardian case, bonds disappear from the government budget constraint. When 6 equals zero, (2.15) becomes

g,w = Mt-w-1
PC

(2.16)

Eq. (2.16) states simply that government bonds do not affect money creation
when they are completely backed by taxes.
Lastly, we assume the government regulates the relative supplies of money
and bonds via open market operations. Let
i=----- M
M,+ B,

(2.17)

where Z, is assumed to be i.i.d. and has mean F. This policy targets the
money-debt ratio. We shall subsequently consider a rule which targets money
growth.
2.3. Equilibrium

The rational expectations competitive equilibrium is defined by the stochastic sequence of prices in the model { u,, i,, P,};,~ which satisfy the following
asset market clearing conditions currently and at all times in the future:
m=M,

(money),

b = B,

(bonds),
(equity).

#=l

(2.18)

Initial values of the asset stocks MO and B, at f equals 1 are taken as given.

S. R. Aiyugari

and M. Gerrler,

The backing

of government

bona5 and monetarism

21

3. Analysis
We are now able to consider the implications of the Ricardian versus
non-Bicardian fiscal regimes, and analyze the consequences for the various
monetarist propositions. We first present the case where any direct taxes
connected with government bonds are levied in a manner which precludes
redistributive effects.* In this initial case, adjustments in the quantity of
government bonds will not directly affect private budget constraints. This
approach will allow us to focus on the relationship between the government
budget constraint and the effects of bonds. Given this restriction on tax levies,
we proceed to characterize the equilibrium for the Ricardian and non-Ricardian
regimes. We then consider the case where direct tax levies may be redistributive. By doing so, we will be able to draw a connection between our analysis
and the earlier results of Patinkin and Mundell.
3.1. Equilibrium

with a distribution-neutral

direct tax policy

A policy which keeps the individuals lifetime direct tax burden independent
of government bonds, and which is consistent with the tax rule (2.8), is

T,(t)= -(l-S)

(1 +BBl&, 7
(3.0

T&)=(1-6)+.

Under this plan, the present value of each agents lifetime direct tax burden is
zero:

Ty(t)+T;(t)=Ty(t)+ E,b& + 1))

(I+ i,)E,(p,/p,+l)=*

(3.2)

Each period, the old pay the fraction (1 - S) of the current bond obligation. In
the meantime, the young receive a subsidy equal to the present value of their
future tax obligation. It is important to stress that eq. (2.8) continues to define
the total direct tax levy each period, and that the present value of this stream is
still the fraction (1 - 8) of the current bond obligation.
To find an equilibrium, first incorporate (3.1) and (3.2) in the asset demand
functions (2.5) and (2.6); then combine the latter with the market clearing
Of course, this consideration is unimportant in the environment considered by Barre (1974).
where intergenerational caring can effectively eliminate the heterogeneity in the overlapping
generations setup, assuming either the bequest or the transfer motive is operative at all times. As a
result, bonds do not directly matter to private budget constraints, and hence do not have
redistributive effects. [For a critique of this view refer to Tobin (1980, ch. 3).] Though, the issue of
how government bonds are backed will remain relevant.

28

S.R. Aiyagari

conditions

and hi. Gertler,

The backing

of government

bonds

and monetarism

(2.18) to obtain
M,
Pr

-=2/3qw,

(1+i)
4

(3.3)

(1:;)p, + u, = (1 - P/i,)

qw.

(3.4)

Note that the first term on the left of (3.4) is the net value of government
bonds to private wealth owners. It is the difference between the market value
of the bonds and the present value of the future direct tax liability connected
with them, that current wealth owners must eventually pay. The parameter 6
reflects (inversely) the degree of offsetting capitalization, and emerges from the
government policy rules (2.8) and (3.1).
We look for a stationary solution, where the asset price is a constant and
given by
u, =

eqw,

(3.5)

where 0 is an as yet undetermined

becomes

84

coefficient. The expression for bonds (3.4)

= (1 -e - p/i,)qw.

(1+ it) PI

Eqs. (3.3) and (3.6)

tively, given the tax
with the monetary
bonds. Manipulating

M,+S=

(3.6)

characterize the demands for money and bonds, respecpolicy and 8. The government budget constraint together
policy rule (2.17) regulates the supplies of money and
(2.15) yields

M,-, + aB,-, +p,&w.

The open market policy (2.17) determines how the left side of (3.7) is divided
between money and bonds. An equilibrium for the sequence of prices { p,, i,},
given 8, is found to be
Pt = ct

M,-, + 6B,-,
w

(3.9)

S. R. Aiyagari

and hf. Gertler,

The backing

of government

bona3 and monetarism

29

where
F,= [(l -e+p)7l-&]-.

(3.10)

Invoke arbitrage to find an explicit value for 8. An expression for the real
return on bonds in terms of 0 follows from the demand and supply relationships for money and bonds, (3.3), (3.6), (3.7):

I= [77(1--e)l-[(1-e+P)17-g,+~].
(1+i,)pp,l

(3.11)

Given (3.5) and the constancy of the dividend stream, the real return to equity
is simply
d,+1+

u,+1

0,

= l+

hw.

(3.12)

Equate the expected values of (3.11) and (3.12), as (2.4) requires, to derive a
solution for 8:

e=

d
d+w(PvE)

Eq. (3.13) confirms the conjecture that 8 is a constant.

The sequence of prices in the model { u,, p,, i,} is completely characterized
by eqs. (3.5), (3.8), (3.9) and (3.13). Further, it is clear from (3.5) and (3.12)
that the equity price u, summarizes the behavior of the real interest rate.
Finally, the consumption allocations can be obtained from the budget constraints (2.2) and (2.3):

c,(t) = ww,

(3.14)

c,(t) = d+ [(I+ 8h -&I w.

3.2. Ricardian verse non-Ricardian regimes

Recall that in the polar Ricardian regime (R) 6 equals zero; government
bonds are backed completely by direct taxation; they vanish from the govemment budget constraint in the sense that they do not affect the path of the
money supply. Conversely, 6 equals unity in the polar non-Ricardian (NR)
regime; government bonds signify a stream of future money creation. We now
compare behavior across regimes and evaluate the monetarist propositions.
It is useful to first recognize that the real variables are independent of the
quantities of money and bonds. These variables include the asset price and the

30

S, R. A(vaguri

and M. Gertler.

The hocking

o/gocrertmenr

hands

arid moueturism

consumption allocations, defined by (3.5) (3.13), (3.14) and (3.15). The irrelevance result is due to the frictionless nature of the model and to the tax policy
which controls for the distributional effects of any direct taxes connected with
the bonds. Further, in this case, the real variables are independent of the
prevailing fiscal regime; the solutions are independent of 6.
The behavior of the nominal variables, however, differs across the fiscal
regimes. The proposition that government bonds are irrelevant is invalid
outside the polar Ricardian regime. There is a continuum of possible outcomes
for the price level and the nominal interest rate; further, the polar Ricardian
and non-Ricardian regimes provide the boundary values in each case. From
(3.8) and (3.9),
M
p,(R)=C,+hp,=F,

(w-t

+w W-t)

Ip

pR)

= F PC-t
I

+ B,-1).
W

(3.16)

(3.17)
where t, is defined in (3.10). Except in the polar Ricardian case, the quantity of
bonds enters the solution both for the price and the nominal interest rate. It
enters the former directly and the latter indirectly via the money debt ratio 2,.
Eq. (3.16) indicates that, in general, the price level depends on M,-, and
B,-l, the beginning-of-period
stocks of the non-interest and interest bearing
debt, respectively.4 We may interpret adjustments in M,-, and B,-, as
corresponding to the traditional conceptual experiments of helicopter drops
(or lifts) of money and bonds. A quantity theory relationship between money
and the price level emerges only in the polar Ricardian case.6 Otherwise,
government bonds matter. Their influence on the price level increases with S,
In an earlier version of this paper, we demonstrated
that when there is substitutability
between
the consumers
budget shares devoted to liquidity
services and to consumption
- so that consumption depends on the nominal interest rate - then a permunenr
change in the money-debt
ratio will
affect the real interest rate in the non-Ricardian
case. due to a Mundell-Tobin
effect. Further,
real
variables
depend on the fiscal regime, characterized
by 6. There is no empirical
evidence, however,
which indicates
that the nominal interest is a significant
determinant
of consumption.
Finally.
all
the other qualitative
results in the analysis are independent
of the particular
utility specification.
4Bryant
and Wallace (1980a) also develop a general equilibrium
monetary
model where the price
level depends
on the complete
supply of government
liabilities.
They do not. however,
discuss the
link between the influence
of government
bonds on the price level and how the bonds are backed.
In this case, the drop (or lift) is made to the old agent so as not to affect the demand for money
or bonds coming from the young agents.
Wallace
(1981)
provides
another
example
where
the quantity
theory
may not hold. He
demonstrates
that an open market exchange between money and private capital will have no effect
on the price level (or any other variable),
presuming
that taxes and transfers
adjust to keep the
deficit and the distribution
of wealth constant.

S. R. Aiyugari

and M, Gerrler,

The bucking

of government

bonds

und monetarism

31

the commitment they represent-to print money. The resulting anticipated rise
in future money creation associated with an increase in 6 lowers the current
demand for nominally denominated assets, which in turn induces a higher
price level. In the polar non-Ricardian case, there is a proportionate link
between p, and the total stock of government liabilities. A bond backed
completely by future money creation thus has the same effect on the price level
as a similarly denominated unit of money.
Eq. (3.17) indicates that the nominal interest rate depends on the relative
supplies of money and bonds; as in the conventional IS/LM framework, it
varies inversely with 2,, the money-debt ratio. The nominal interest rate
adjusts to regulate the relative demands for money and bonds. The influence of
5, disappears in the polar Ricardian regime. In this case, any change in the
supply of bonds does not affect equilibrium prices, including i,, due to the
accompanying adjustment in current and future direct taxes. For example, a
rise in the quantity of bonds sold at t lowers the current and raises the future
tax on the young agent, in a manner which keeps his permanent income
unchanged. He simply absorbs the bonds at prevailing prices, and then uses
the proceeds to pay taxes in the future.
It is now apparent that, outside the polar Ricardian regime, the channel
through which money enters the economy matters. Consider the effects of a
change in the path of the money supply from M,-, to M, due to a temporary
adjustment in open market policy (a blip in 2,) versus a temporary change in
fiscal policy (a blip in 8,). While the monetary policy alters the nominal
interest rate, it does not affect the price level, as (3.8) and (3.9) indicate. The
movement in the nominal interest rate adjusts the demand for money to match
the change in supply; thus the previous price level remains consistent with the
equilibrium.
On the other hand, a change in M, due to a temporary adjustment in fiscal
policy precipitates a proportionate change in the price level, but no change in
the nominal interest rate. Monetary policy (2,) is held constant during this
experiment, which requires that the quantity of bonds must adjust to keep the
money-debt ratio unchanged. Otherwise, there would not generally be a strict
proportionate link between M, and pr, and the nominal interest rate would
vary. These results are apparent from inspection of the money market equilibrium (3.3) and the reduced form for the nominal interest rate (3.9). The
critical difference between the monetary and fiscal experiments is that the
former changes the composition of government liabilities at t without affecting
the total supply, while the reverse is true for the latter. This distinction is
unimportant only in the polar Ricardian regime where government bonds are
completely irrelevant.7
More specifically, in the polar Ricardian case, the time path of the money supplyis uniquely
determined by fiscal policy, as (2.16) indicates. An adjustment in the money-debt ratio only affects
the quantity of bonds, due to the corresponding change in direct tax levies.

32

S.R. Aiyagari

and h4. Gertler,

The backing

of gooernmerrr

bonds and mouerarism

The analysis of the link between government bonds and nominal variables is
clearly similar to Patinkin and Mundell. However, the traditional literature
also suggests that open market activity can affect the real interest rate as well
as the nominal, even in a frictionless setting. This conclusion is at least in part
due to the static nature of the conventional IS/LM model, in which inflationary expectations are exogenous. Thus, changes in the nominal rate always
imply changes in the real rate. In our example, the real interest rate is
independent of open market activity, according to (3.5), (3.12) and (3.13).
Instead, the inflation rate and hence the expected inflation rate (via rational
expectations) adjusts to movements in Z, to exactly offset changes in the
nominal interest rate. This neutrality proposition relies on the policy (3.1),
which precludes redistributive effects from any direct taxes which back government bonds.
The neutralizing adjustment in inflationary expectations can be traced to the
government budget constraint. Consider a fall in the money-debt ratio precipitated by an open market sale. The resulting increase in the nominal interest
rate implies that the growth of outside debt must be larger than otherwise to
satisfy the government budget constraint. There will be a corresponding
change in next periods price level p,+i, as the updated version of (3.8)
suggests. The resulting changes in the flow of new government debt and in the
actual and anticipated inflation rates will be consistent with an unchanged real
interest rate. Thus, the open market experiment is neutral with respect to real
variables. In the next section, though, we demonstrate that it is possible to
reproduce Patinkin and Mundells results by allowing the direct tax backing of
bonds to be redistributive.
An expression for the gross inflation. rate follows from (3.9), (3.10) and
(3.11). As with the price level and the nominal interest rate, there is a
continuum of outcomes bounded by the polar Ricardian and non-Ricardian
regimes:
~(R)=(l+~)~(l-B)t,+,<~=(l+i,)n(l-e)~,+~
I

)n(l - wr+lY

(3.18)

where Ft+ i and i, are defined by (3.10) and (3.9), respectively. Eq. (3.18)
confirms the earlier discussion regarding the response of inflation to open
market operations. The gross inflation rate varies proportionately with the
nominal interest rate, leaving the real interest rate unchanged.
Eq. (3.18) also illustrates Sargents (1982b) emphasis on the connection
between inflation and the fiscal backing of government liabilities, resulting

S. R. Aiyagari

and hf. Gertler,

The backing

of government

bona% and monetarism

33

from his study of the hyperinflations in post World War I Europe. The
inflation rate progressively increases as the economy moves from the polar
ficardian to the polar non-Ricardian regime. In the former case, bond issues
are not inflationary, since they represent a promise to raise direct taxes, rather
than print money. They are inflationary in the latter case, since they imply the
need to issue more government liabilities in the future to finance the higher
interest payments. For similar reasons the price level and the nominal interest
rate increase continuously as the regime becomes more non-Ricardian, as
(3.16) and (3.17) show. These results demonstrate precisely how the value of
the governments nominal liabilities depends on the future fiscal policy backing
the existing stock of debt.
What is perhaps less obvious is that monetizing the debt lowers inflation,
except in the polar Ricardian case. This occurs because the higher money-debt
ratio reduces the nominal interest rate, which in turn lowers the flow of new
government liabilities. Inflation falls accordingly, as can be seen from (3.18).
We now turn to a discussion of the Fisherian theory. Let (1 + r) be the gross
real return on equity, equal to (d+ u)/u. From (3.12) and (3.13) we see that
(1 + r) is independent of either temporary or permanent changes in the
money-debt ratio. From (3.3), (3.6) and (3.8) we have

M = 0 + 4)
, ~Lw,(w-l+

W-l),

Using the above equations together with (3.8), it is easy to deduce that

lL+L=i 1

o+dE

r+l

Et

it

M,+ 6B,(l+

jr+1

i l+i,+i

i,)-l
]=&=E,(&).

W+I + W+l(l

(3.19)

(3.20)

+i,+d-l

Eq. (3.19) shows that when there is a temporary change in the money-debt
ratio, the simple Fisherian link between the gross nominal interest rate and the
anticipated money growth rate does not hold in the short run. This occurs
because in general the price level and hence the inflation rate depend on the
behavior of the complete stock of government liabilities, as discussed earlier.
Temporary changes in the money-debt ratio thus cause a divergence between
the anticipated money growth rate and the anticipated inflation rate. Eq. (3.20)
shows that the anticipated inflation rate matches the anticipated growth rate in

34

S. R. Aiyaguri

and M. Gerrler.

The hacking

of gooerntttenr

ho&

attd ntotteturisnt

the total market value of government liabilities from t to t + 1. Thus the

short-run Fisherian relationship holds with respect to this financial aggregate,
which includes the market value of unbacked government. bonds. We demonstrate in the next section though that the Fisherian theory does hold for the
long-run with respect to permanent changes in the money growth rate associated with permanent changes in the money-debt ratio.
Only in the polar Ricardian case (6 = 0) does (3.20) suggest a relation
between the anticipated money growth rate and the gross nominal rate.
However, the Fisherian theory is still not generally valid. In this case, the
money supply is determined solely by government spending, according to
(2.16); the money-debt ratio instead determines the quantity of bonds. Further, only permanent changes in government spending will affect the anticipated money growth rate; temporary changes alter only the actual money
supply.* A permanent increase in g affects the real interest rate as the presence
of g in 8 [eq. (3.13)] indicates. This behavior reflects the familiar
Mundell-Tobin
effect which arises because the resulting increase in anticipated
inflation induces agents to shift their portfolios from nominal assets to equity,
thus raising its price and lowering its real rate of return. Consequently the
gross nominal rate will not vary exactly with permanent changes in the money
growth rate, induced by changes in g. In appendix I we demonstrate that, if
the fiscal authority cooperates by correcting for the distributional consequences
of the inflation tax, then the Fisherian theory will emerge in this case. Thus,
while a certain degree of fiscal accommodation of monetary policy is necessary
to generate the irrelevance of government bonds and the quantity theory, an
even greater degree is necessary to make.the simple Fisherian theory apply.
3.3. Equilibrium

with a non-neutral direct tax policy

In the previous section, when government bonds matter, an open market

exchange affects the nominal but not the real interest rate. This behavior
contrasts with Patinkin and Mundell, where the real rate adjusts as well. Our
result arises, in part, because the fiscal adjustment to bond issues does not
affect private budget constraints. We now consider an alternative tax policy
which allows government bonds to directly affect private budget constraints
due to the heterogeneity in the OLG model, as in Diamond (1965). This
approach will lead to conclusions which parallel the traditional analysis.
We introduce a policy where the savers are responsible for the current
interest obligation on the debt, and the dissavers pay nothing. Replace (3.1)
sNote that a temporary increase in current government consumption does not affect the real
interest rate in this framework. Rather, it crowds out consumption spending by the old [see (3.15)].
A temporary change in & affects the price level which in turn affects the value of the government
liabilities held by the old. EKects on v could be introduced in this framework by providing the
young with nominally denominated transfers.

S. R. Aiycrgari

and M. Gertler,

The backing

of government

bon&

and monetarism

35

with

(3.21)
To(t) = 0.
Notice that (3.21) satisfies the tax rule (3.1), so that (1 - S) remains the
fraction of the debt backed by direct taxation. However, the present value of
each individuals lifetime tax burden becomes

whereas before it was zero, according to (3.2). A young agents lifetime tax
burden now varies positively with the governments current obligation on its
debt.
We seek a stationary solution for this case by assuming, for computational
ease, that the government policy variables z and 2 are no longer stochastic but
instead assume the constant values z and g, respectively. By proceeding
as before, we calculate the following solution for the prices in the model, u, p
and i:
(3.22)

u = O?j(l - qw,

p=u

Ad,-, + 6%1
w

i=jqz,

(3.23)

(3.24)

where 8, Y and r are given by

d

(3.25)

e=d+w[/3q-g+r(l-/3)]

(3.26)

v= [r+n(l-r)(l-e+/3)-g]-,
r=

o-we-d

&+S+Pq(l-6)

(3.27)

=T,w

36

S. R. Aiyagari

and M. Gertler,

The backing

of government

bonds

and monetarism

Eq. (3.27) is a reduced form expression for the young agents lifetime tax
burden, as a fraction of his endowment.
In between the two polar regimes, when S lies between zero and unity, a rise
in the money-debt ratio will simultaneously lower the nominal and the real
interest rates, as in the traditional literature. Eqs. (3.22) (3.25) and (3.27)
indicate why the open market policy has real effects in this case. The policy
redistributes the burden of government finance between savers (the young) and
dissavers (the old). A rise in z lowers the quantity of bonds and accordingly
lowers the tax obligation savers face. The rise in savers permanent income
increases the demand for equity, which raises its price and accordingly lowers
the real interest rate. The demand for consumption goods by savers also rises,
which increases the price level and therefore depreciates the nominal assets of
the dissavers. The open market purchase accordingly lowers the real interest
rate by redistributing wealth toward savers.
4. Time series implications and long-run monetarist behavior
The issue arises of whether the evidence of long-run correlations between
money and the price level and between money growth and nominal interest
rates indicates a monetarist/Ricardian
regime. We demonstrate to the contrary
that the non-monetarist/non-Ricardian
economies in our analysis will have the
same long-run correlations, but for somewhat different reasons. On the other
hand, these economies also explain a stylized fact relating to the short run, an
inverse relation between temporary changes in the money growth and nominal
interest rate. This behavior arises despite the absence of the usual frictions.
We return to the framework in section 3, where direct tax levies did not
affect distribution. Further, let 6 exceed zero, so the economy is not in the
polar Ricardian regime. We will show that the economies in this case will
exhibit the observed long-run correlations because the central bank is constrained to keep the long-run average growth rates of money and bonds
identical. Thus, for this exercise to be meaningful, it is necessary to allow the
money-debt ratio to wander in the short run. Replace the rule (2.17) which
pegs the money-debt ratio, with the following time stationary policy:
M,= [l +IZ,+A(i,_,E,(l/i)-l)]M,-,,

II,A>O,

(4.1)

where E, is the unconditional (steady state) expectation operator, and where p

is an i.i.d. random variable with mean ~1.
Under (4-l), the central bank targets the money growth rate at the average ~1,
but leans against the wind in response to deviations of the nominal interest
rate from its steady state value. The feedback term in (4.1) is necessary to
avoid the type of instability problem discussed by Sargent and Wallace

S. R. Aiyugari

mu/ M. Ceder,

The backing

of governmem

bonds ON/ moneturism

31

(1981).9 Unless taxes adjust to exactly offset fluctuations in the obligations on

government bonds (i.e., unless we are in a polar Ricardian regime), a simple
Friedman monetary rule will cause the nominal interest rate and the quantity
of bonds to rise or fall without bound. As implied earlier this stability
consideration is what leads the non-Ricardian economy to appear monetarist
in the long run; it forces money growth over time to stay in line with the
growth of the total supply of government liabilities.
The expressions for equilibrium prices remain the same as described by (3.5),
(3.8), (3.9), (3.10) and (3.13). The only difference is that the money-debt ratio
is now endogenous, since the central bank is targeting money growth. The
nominal interest rate is accordingly no longer i.i.d., and is instead serially
correlated.
A stochastic difference equation for the nominal interest rate may be
developed as follows. Equate the money supply rule (4.1) with money demand
(3.3):
(4.2)
Then substitute (3.8) for the price level in (4.2) and manipulate
following difference equation which is linear in (l/i):

to obtain the

It can further be seen from (4.3) that

E ( f 1 = (1+,)(11+/+1
where 1 + r is the gross real rate of return on equity. Fir&y,
conditions ensure that (4.3) is stable:
O<(l+i$-A)[~(l-O)j.$]-l<l,
[v(l - e>p,] -l>

(1+ r)(l

the following

(4.5)
+ /.l) - 1.

(4.6)

McCallum (1984) provides a lucid discussion of this issue. He considers the feasibility of a
policy, where a permanent deficit is financed purely by bonds, and the money stock is held
constant. He demonstrates that an equilibrium with a stable price level is feasible if the deficit is
defined to include the interest obligation on the debt, but not feasible otherwise. The former case
corresponds to the polar Ricardian regime in our examples. The policy is feasible since taxes are
adjusting to meet the obligation on the bonds. The latter case is not feasible, since neither taxes
nor money is adjusting to pay for the bonds. Hence, the supply of bonds will grow without bound,
if the interest rate exceeds the growth rate.

38

S. R. A(wguri

und M. Gertler.

The backing

of govertmerrr

bonds

atld motterurism

The behavior of the nominal interest rate differs in the short and the long
run. Eq. (4.3) indicates that the nominal interest rate varies inversely with
temporary fluctuations in money growth (blips in p,). This result is typically
associated with sluggish price models. It arises in this situation because of the
effect of adjustments in money growth on the relativesupplies of money and
bonds, which determine i, as described in section 3.
Invert (4.4) to obtain a relationship for (approximately) the long-run average
gross nominal interest rate:
- =(l+r)(l+/l).

(4.7)

Eq. (4.7) indicates that, except for the qualifications introduced by Jensens
inequality, lo the Fisherian theory of interest holds for the long run, even
though the money-debt ratio governs the nominal rate in the short run. The
(approximate) steady state gross nominal interest rate equals the mean gross
money growth rate times the mean gross real interest rate. This behavior arises
because the feedback term in (4.1) ensures that in the steady state money
growth is in line with the growth in total public liabilities.
Finally, a change in the mean gross money growth rate will lead to a
proportionate change in the long-run average gross inflation rate. This result
arises since the gross inflation rate is proportionate to the gross nominal rate,
according to (3.18). Hence, the mean steady stare inflation and nominal
interest rates (approximately)
appear to obey the simple quantity and
Fisherian theories, even when the fiscal regime is not purely Ricardian.
However, it is important to emphasize that this long-run behavior occurs
because the central bank must keep the money-debt ratio stable on average,
and not because it is only (the current supply of) money which matters.
5. Concluding remarks

Our analysis details the link between the governments fiscal backing of its
interest-bearing debt and the outcomes of certain conventional monetary and
fiscalexperiments. The results indicate that the validity of certain propositions
usually considered monetarist depends on how government bonds are backed.
A more fundamental interpretation of the analysis is simply that the effects
of various standard macroeconomic policies depend on the on-going interaction between the monetary and fiscal authority. As we discussed, the backing
of government bonds is a measure of the extent to which fiscal policy
accommodates monetary policy, and vice versa. In this context, the results
indicate that the validity of basic monetarist hypotheses requires a consider%

particular,

E(l/i)

+ (l/E(i)).

S. R. Aiyuguri

and M. Gerrler,

The backing

of government

hondr

and moneturism

39

able degree of accommodation by the fiscal authority. It must fully back

government bonds with future direct tax levies to generate: (a) the irrelevance
of government bonds, (b) the quantity theory, (c) the unimportance of how a
change in the money supply is made. Further, in the absence of integenerational caring, as in Barro (1974), it is also necessary for the fiscal authority to
offset any redistributive effects of the bonds. Finally, in addition to the other
requirements, fiscal policy must compensate for the distortion due to the
inflation tax, in order for the Fisherian theory of interest to hold.
When fiscal policy is not fully accommodating, that is, when bonds are
backed in part by future money creation, government bonds will matter to the
price level and the money-debt ratio affects the nominal interest rate in a
conventional manner. Further, the bonds will introduce real effects either if
fiscal policy does not control for the effects on the distribution of wealth, or if
frictions such as nominal rigidities or legal restrictions are present. While our
conclusions in some respects parallel the traditional analysis by Patinkin and
Mundell, our method differs. Rather than arbitrarily postulating how agents
discount government bonds, we derive the capitalization rule as the outcome of
a rational forecast, given the prevailing fiscal regime.
Two final issues arise. The first involves the empirical implications of the
analysis. We demonstrated that the evidence of long-run correlations between
money and certain nominal variables does not provide evidence for the
monetarist regime. These correlations can arise in regimes where the total
supply of government liabilities affects nominal variables; they arise simply
because stability conditions preclude the central bank from allowing the
money growth rate to persistently deviate from the growth of the total stock of
government debt. On the other hand, recent evidence by Blinder (1982),
demonstrating that in the period since 1960 government bonds had an influence on nominal income which was independent of the effects of bank
reserves, suggests that the non-monetarist setting may be relevant to current
behavior. Clearly, this issue should be investigated further.
The final related question involves what determines how government bonds
are backed. This issue requires a positive theory of government finance and, in
particular, of the interaction between the monetary and fiscal authorities. The
problem must be addressed in future research.
Appendix I

The Fisherian theory in the polar Ricardian regime

In the text we found that while the presence of a polar Ricardian regime
may be a necessary condition for the pure Fisherian theory to hold, it is not
sufficient, because of the presence of a Mundell-Tobin
effect. Here, we
demonstrate that if taxes and transfers control for the distributional effects of

40

S. R. Aiyagari

and hi. Gertler,

The backing

of gooertrment

bonds

and monetarism

the inflation tax, the pure Fisherian theory will arise in the polar Ricardian
case.
We return to the framework characterized by section 3.2 in the text, and in
particular to the case where government bonds are completely backed by taxes
(6 equals zero). For expositional convenience, we will simply ignore bonds,
since they are totally irrelevant in this case anyhow. Thus, the tax policy
described by (2.8) and (3.1) is no longer relevant. Further, we wish to vary the
money growth rate independently of government spending in order to control
for the real effects of the latter. We do this by appropriately adjusting taxes
and transfers. Finally, we assume that government spending and the money
growth rate are. non-stochastic and equal to the constant values g and fi,
respectively. Taxes are adjusted in accordance with the following scheme:

(I-1)
(I-2)

where r is the real interest rate. According to (1.1) and (1.2), the present value
of the lifetime tax burden remains zero. It follows from (2.6) in the text, that
the equilibrium relation for the price of equity can be expressed as
u, - 70\f~f1

= (1 - @/i)qw.

However, given (1.2), the solutions for u, and r( = d/u) are the same as given
by eqs. (3.5) and (3.13). The solution for real money balances also remains
identical to (3.3) in the text.
By updating (3.3), we can write
-=-1
l+F

Combining

PI
P,+1

(1.4)

(1:4) with the arbitrage relation (2.4) implies

(1 + i) = (1 + F)(l + r).

(1.5)

We simply need to show that r is independent of F. Inspection of (3.5) and

(3.13) indicates that this requires only that F and g can be selected independently. The tax policy (1.1) and (1.2), however, ensures this result. Substituting

S.R. Aiyagari

and M. Gertler,

The backing

of government

bonds

and monetarism

41

(I.l), (1.2), and (3.3) into the government budget constraint yields

=Bllw[-l+;++$]+gw,
gw=pvw

-1+1:

i+

(1.6)

1-L i +gw,

Hence, under the tax policy (1.1) and (1.2), the level of government expenditures does not place any restriction on the money growth rate. Thus, the choice
of F does not affect r. The simple Fisherian theory therefore holds in this case.
Appendix II
Extensions to a production economy

We now demonstrate that the analysis extends easily to a production

economy. This exercise may be of independent interest, because the resulting
framework is an intertemporal general equilibrium model, with all the descriptive characteristics of the traditional flexible price IS/LM model. We shall
provide only a brief characterization of the model; it is straightforward to
verify that all the basic conclusions in the text are unaffected by this modification.
Assume that the young agent inelastically supplies one unit of labor at the
real wage rate w, which is competitively determined. Thus, labor income
replaces the endowment in the consumers demand functions. Second, the
equity now represents a claim to the earnings stream of physical capital
operated by firms. The behavior of the government sector is the same as
characterized in section 3, except that government expenditures are now
proportional to real output.
For simplicity, we assume there is a single firm which acts competitively. The
firm hires labor, produces output with labor and capital inputs, and invests
with retained earnings. Profits which are not retained are paid as dividends to
shareholders. As before, there is one perfectly divisible share outstanding. The
firm has K,-i units of capital at the beginning of period r. The production
function is
y

= NYKl1-Y
I
I

1,

O<y<l,

(11.1)

42

S. R. A@gari

und M. Gertler,

The bucking

of gooernmenr

bonds

atld monetarism

where Y, is real output at t and N, is the firms demand for labor at t.

Investment obeys the following cost-of-adjustment mechanism:
(11.2)

O<h<l,

where H, is gross investment at t. Capital lasts for one period. However,

adjusting the size of the firm involves costs, embodied in the parameter h. The
costs are infinite when X equals zero and are absent when h equals unity.
Dividends consist of output minus the sum of the wage bill and investment.
That is,
d, = r, - w,N, - H,.

(11.3)

The firm chooses employment and investment to maximize the present value
of its earnings stream. Let q, equal u/K,, the post-dividend value of shares at
time t per unit of capital, after investing at t. The firm accordingly solves the
following problem:
maxq,K,+
N,.H,

Y,- w,N,- H,,

(11.4)

subject to (11.1) and (11.2). The first-order conditions imply

w,N,=

(11.5)

vr,,

(11.6)

H, = K,&q,)?

Investment depends on the average price of capital, since the adjustment-cost

and output technologies are constant returns to scale. A supply curve for
capital is obtained by combining (11.6) with (11.2):
(11.7)

K,= K,&q,)XA-X).

The rate of return to equity is found from (II.l), (11.3) (IIS), (11.6), and (11.7):
d,+1

+u,+1
t

=r

1+1
[

~(~q,+l)l/(~-~~

q,,

(11.8)

I/

where ~,+i is the marginal physical product of capital at t + 1.

We wish to find an equilibrium for the sequence of prices (q,, p,, i,, w,}.
Note that we are solving for the price of equity per unit of capital instead of
the total value of equity, in contrast to the analysis in the text where the

S. R. Aiyagari

and M. Gertler,

The bucking

of government

bonds

und monerurism

43

distinction is unimportant. In addition, the introduction of the labor market

implies the need to solve for w,. The solution procedure is essentially the same
as in the text; however, there is the added complication that the capital stock
varies over time.
We seek a solution which is a time-stationary function of the capital stock.
Begin with the conjecture
(11.9)

q,K, = by?

where 7 is defined by (2.6) and, as before, 8 is an undetermined coefficient. By

equating demand with supply in the three asset markets and the labor market,
we obtain solutions for {q,, p,, i,, w,}, given 8:
(11.10)

q, = A-*[@WV,-,I-,

i =P
PC= cr

6+1-a

l-81,

M,-,

+ 6B,-,
r,

w,=vr,,

(11.12)
(11.13)

where
E,= [(i-e+~hY-g,l-l,
Y, = K,-,,

(11.14)

since N = 1. As before, we use the arbitrage condition (2.4) to find a solution

for 8:
(11.15)
Eq. (11.15) confirms that the solution for 8 is a constant. There exists a unique
solution for B which lies between zero and unity if
b/Y E-

(11.16)

This restriction limits g, the average fraction of output the government

consumes. It ultimately places a bound on inflation which ensures that the
steady state net real interest rate is positive.
It is clear from eqs. (11.8) through (11.14) that the conclusions regarding the
effects of Ricardian versus non-Ricardian fiscal regimes also apply to the

44

S. R. Aiyagari

and M. Gertler.

The bucking

of gooernmerrt

bonds md

nlonerbrism

production economy. When adjustment costs are infinite (when h equals zero)
so that the capital stock cannot be changed, eqs. (11.8) through (11.14) become
identical to their counterparts in the text. Otherwise, any change in the price of
equity will induce an adjustment in the capital stock, in contrast to the
endowment economy.
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1095-1118.
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