Monetary Policies with Increasing Returns

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Discussion Paper

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The paper studies a two-sector monetary economy with two factors of production, labor and capital. The industrial sector has increasing returns to scale, the consumption sector non-increasing returns. All firms maximize profits and markets clear. For each rate of return on capital the model reaches a general equilibrium with an associated demand for money. A monetary policy is a quantity of money supplied. We prove that restrictive monetary policies decrease the level of operation and profits of the increasing returns to scale sector and eventually force it to operate with negative profits, so that it must close down. The other sector of the economy, however, expands with more restrictive monetary policies, but national income as a whole decreases. Monetary policies affect the rate of interest of the economy and determine whether or not competitive market equilibria exist with a positive output in the increasing returns sector. With very restrictive monetary policies, the only market equilibria with continued output from the increasing returns sector are those where this sector is being subsidized. There are, therefore, two choices open to this economy: either adequate liquidity is provided to allow the increasing returns sector to behave competitively and produce positive output, or else this sector must be regulated and subsidized to prevent it from closing down.

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