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Elastic Money, Inflation, and Interest Rate Policy

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Author Info
Allen Head () (Queen's University)
Junfeng Qiu () (Central University of Finance and Economics, Beijing)

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Abstract

Optimal monetary policy is studied in an environment in which money plays an essential role in facilitating exchange and aggregate shocks affect individual agents asymmetrically. Exchange may be conducted using either bank deposits (inside money) or fiat currency (outside money). A central monetary authority both controls the stock of outside money and pursues an interest rate policy that affects the rate at which private banks create inside money. We find that the optimal monetary policy requires management of both interest rates and the quantity of outside money. By controlling interest rates the monetary authority can affect the price level in the short-run and adjust households' consumption, thus providing insurance against unfavorable aggregate shocks. The feasibility of the interest rate policy requires a minimum rate of trend inflation that may be positive and in principle quite large. The paper thus links two principal components of monetary policy: the optimal interest rate policy and the optimal long-run inflation rate.

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File URL: http://www.econ.queensu.ca/working_papers/papers/qed_wp_1152.pdf
File Format: application/pdf
File Function: First version 2007
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Publisher Info
Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1152.

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Length: 41 pages
Date of creation: Dec 2007
Date of revision:
Handle: RePEc:qed:wpaper:1152

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Related research
Keywords: banking; inside money; elastic money; monetary policy; inflation; zero bound;

Other versions of this item:

Find related papers by JEL classification:
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Champ, B. & Smith, B.D., 1991. "Currency Elasticity and Banking Panics: theory and Evidence," University of Western Ontario, The Centre for the Study of International Economic Relations Working Papers 9109, University of Western Ontario, The Centre for the Study of International Economic Relations.
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  2. Freeman, Scott, 1996. "Clearinghouse banks and banknote over-issue," Journal of Monetary Economics, Elsevier, vol. 38(1), pages 101-115, August. [Downloadable!] (restricted)
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  3. Cavalcanti, Ricardo & Erosa, Andres & Temzelides, Ted, . "Private Money and Reserve Management in a Random Matching Model," Working Papers 97-17, University of Iowa, Department of Economics, revised Sep 1997.
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  4. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December. [Downloadable!] (restricted)
  5. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
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  6. Aleksander Berentsen & Gabriele Camera & Christopher Waller, . "Money, Credit and Banking," IEW - Working Papers iewwp219, Institute for Empirical Research in Economics - IEW. [Downloadable!]
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  7. Sun, Hongfei, 2007. "Banking, Inside Money and Outside Money," MPRA Paper 4504, University Library of Munich, Germany. [Downloadable!]
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  8. Bullard, James & Smith, Bruce D., 2003. "Intermediaries and payments instruments," Journal of Economic Theory, Elsevier, vol. 109(2), pages 172-197, April. [Downloadable!] (restricted)
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  9. Aleksander Berentsen & Christopher J. Waller, 2009. "Optimal stabilization policy with endogenous firm entry," Working Papers 2009-032, Federal Reserve Bank of St. Louis. [Downloadable!]
  10. Ping He & Lixin Huang & Randall Wright, 2005. "Money And Banking In Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 637-670, 05. [Downloadable!] (restricted)
  11. Ricardo de O. Cavalcanti & Andrés Erosa & Tod Temzelides, 2004. "Liquidity, money creation and destruction, and the returns to banking," Working Paper Series 394, European Central Bank. [Downloadable!]
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  12. Sun, Hongfei, 2007. "Aggregate uncertainty, money and banking," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 1929-1948, October. [Downloadable!] (restricted)
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  13. Aleksander Berentsen & Cyril Monnet, 2007. "Monetary Policy in a Channel System," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
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