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Debt enforcement and the return on money

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  • Rojas-Breu, M.

Abstract

The rate-of-return-dominance puzzle asks why low-return assets, like fiat money, are used in actual economies given that risk-free higher-return assets are available. As long as this question remains unresolved, most conclusions from monetary models which arbitrarily restrict the marketability properties of alternative assets to make money valuable are difficult to assess. In this paper, I provide a framework in which fiat money has value in equilibrium, even though a higher-return asset is available and there are neither restrictions nor transaction costs in using it. I suggest that the use of money is associated with frictions underlying debt contracts. In an environment where full enforcement is not feasible, the actual rate of return on assets is determined by incentives eliciting voluntary debt repayment. I show that the inflation rate or, more generally, the depreciation rate of an asset in which debts are denominated may function as a commitment device. As a result, money is used in equilibrium and the optimal inflation rate is positive.

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Bibliographic Info

Paper provided by Banque de France in its series Working papers with number 345.

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Length: 23 pages
Date of creation: 2011
Date of revision:
Handle: RePEc:bfr:banfra:345

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Keywords: Money; Inflation; Debt Enforcement; Banking.;

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  1. Zhu, Tao & Wallace, Neil, 2007. "Pairwise trade and coexistence of money and higher-return assets," Journal of Economic Theory, Elsevier, vol. 133(1), pages 524-535, March.
  2. S. Rao Aiyagari & Stephen D. Williamson, 1998. "Money and dynamic credit arrangements with private information," Working Paper 9807, Federal Reserve Bank of Cleveland.
  3. Lagos, Ricardo, 2010. "Asset prices and liquidity in an exchange economy," Journal of Monetary Economics, Elsevier, vol. 57(8), pages 913-930, November.
  4. Rao Aiyagari, S. & Wallace, Neil & Wright, Randall, 1996. "Coexistence of money and interest-bearing securities," Journal of Monetary Economics, Elsevier, vol. 37(3), pages 397-419, June.
  5. Díaz, Antonia & Perera-Tallo, Fernando, 2011. "Credit and inflation under borrowerʼs lack of commitment," Journal of Economic Theory, Elsevier, vol. 146(5), pages 1888-1914, September.
  6. Aleksander Berentsen & Gabriele Camera & Christopher Waller, . "Money, Credit and Banking," IEW - Working Papers 219, Institute for Empirical Research in Economics - University of Zurich.
  7. Fernando Perera-Tallo & Antonia Diaz, 2007. "Credit and Inflation under Borrowers' Lack of Commitment," 2007 Meeting Papers 429, Society for Economic Dynamics.
  8. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  9. Christian Hellwig & Guido Lorenzoni, 2006. "Bubbles and Self-Enforcing Debt," NBER Working Papers 12614, National Bureau of Economic Research, Inc.
  10. Fernando Alvarez & Urban J. Jermann, 2000. "Efficiency, Equilibrium, and Asset Pricing with Risk of Default," Econometrica, Econometric Society, vol. 68(4), pages 775-798, July.
  11. Trejos, Alberto & Wright, Randall, 1995. "Search, Bargaining, Money, and Prices," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 118-41, February.
  12. Hellwig, Martin F., 1993. "The challenge of monetary theory," European Economic Review, Elsevier, vol. 37(2-3), pages 215-242, April.
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