The Role of Time Preference, Intertemporal Substitution in a
Forward Looking Model of Aggregate Demand Price Elasticity
JEL Category E00
Macroeconomic Theory
Alternate JEL Category E60
Monetary and Fiscal Policy
A Proposal for Presentation at
The 73nd International Atlantic Economic Conference
Montreal, Canada
October 4th – 7th, 2012
Ben L. Kyer
Professor of Economics
Francis Marion University
Florence, SC 29501
And
Gary E. Maggs
Professor of Economics
St. John Fisher College
Rochester, NY 14618
I. OBJECTIVES
In recent decades, the ISLM model has been reexamined by incorporating a more comprehensive decision-making mechanism which explicitly includes agent expectations, or an assumption of forward-looking behavior. However, despite this advancement in relying upon more realistic assumptions, there has been no attempt to investigate the implications of forward-looking agent expectations on the price-level elasticity of aggregate demand. Such a query would seem to be invaluable, in general, as the impact of both fiscal and monetary policy, including supply-side oriented fiscal policy, is ultimately influenced by the price elasticity of aggregate demand. In recognition of this, the purpose of this article is to investigate the impact of including forward looking economic agents on the price-level elasticity of aggregate demand.
II. DATA/METHODS
The theoretical model is an extended version of the well-known ISLM model that deepens the traditional separation of the goods and money markets by including agent expectations for both aggregate planned spending on goods and the overall price level. Only closed-economy private spending agents exist and, thus, there is no explicit treatment of government or foreign sector behavior or, for that matter, is there any attempt to separate consumer and business private expenditures. Moreover, these homogeneous private spenders are assumed to react to changes in the rate of interest along with changes in expected spending and the price level.
III. RESULTS/EXPECTED RESULTS
The price level elasticity of aggregate demand is shown to be ambiguously related to the interest elasticity of the demand for money. However, in the special case where the elasticity of substitution between current and future goods is greater (less) than one, an increase in the interest elasticity of money demand unambiguously leads to an increase (decrease) in the price level elasticity of aggregate demand. It is also shown that the price elasticity of aggregate demand is unambiguously a positive function of the elasticity of substitution. With these findings, it is interesting to note that from a policy-making standpoint, the magnitude of the interest elasticity of money demand, even in the extreme case of a liquidity trap, does not impact the direction of causation between the elasticity of substitution and the price level elasticity of aggregate demand. Conversely, the direction of causation and ultimate impact of an autonomous change in the interest elasticity of money demand is shown to depend upon the assumed a priori value for the elasticity of substitution between current and future goods.