MONEY AND PRODUCTION - A STOCHASTIC FRONTIER APPROACH

Considerable controversy surrounds the role of money in the production of goods and services. Previous empirical research has appeared to fi nd that the real money stock affects aggregate output, holding other, more conventional inputs constant. However, the theoretical literature offers no convincing explanation for this empirical finding. One inte rpretation is that real money balances reduce the extent to which labo r and capital are diverted into exchange-related activities instead of being used in production defined in a more narrow sense. To investiga te this hypothesis, we estimate a production function augmented with r eal money balances as an input, using time-series data for the aggrega te U.S. economy. A stochastic production frontier is then estimated wi thout real money balances. We use these estimates to establish the pre sence of technical inefficiency. Finally, we show that the extent of t echnical inefficiency is negatively correlated with the real money sto ck. Our results provide a reconciliation between the empirical literat ure, which finds that real money balances affect output in a productio n function framework, and the theoretical literature, which suggests t hat real money balances enhance the technical efficiency of the econom y.