Money Balances in the Production Function: A Retrospective Look

This paper surveys the literature on real balances in the production function since Sinai-Stokes (1972). The discussion has now moved beyond the question of real balances belonging in the production function to the issue of how to model the effect of the financial sector on the real economy. Results reported argue that the effect of the degree of optimality of the financial sector (as measured by the interest rate) is a significant shift parameter in the production function. While this specification may be improved on in future work, results to date indicate that an aggregate production function that does not take into account the effects of the financial sector is not completely specified.