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Endogenous Monetary Policy: A Leviathan Central Bank in a Lagos-Wright Economy

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  • Parag Waknis

    (University of Connecticut and University of Massachusetts Dartmouth)

Abstract

This paper studies the nature of optimal monetary policy under a Leviathan monetary authority in a microfounded model of money based on ?. Such a monetary authority is a reality whenever and wherever fiscal policy is a primary driver of the monetary policy. Under no commitment, we characterize and solve for a Markov perfect equilibrium as well as for equilibrium with reputation concerns. For the Markov equilibrium, a generalized Euler equation is derived to characterize optimal policy that trades off the current benefit of increasing consumption against the reduced ability to do so in the future. Under reputation equilibrium, centralized market interaction is modeled as an infinitely repeated game of perfect monitoring, between a Leviathan monetary authority (a large player) and the economic agents (small players). Such a game has multiple equilibriums but the large-small player dynamics pins down the equilibrium set of payoffs and features less than maximum inflation tax. Depending on how we interpret the Leviathan central bank, the factors determining the realized equilibrium differ. Higher fiscal profligacy of the underlying political authority leads to a higher monetary growth rate and inflation tax, while existence of threat of competition in case of a private money supplier or threat of external aggression in case of a self interested sovereign leads to a lower one. The realized equilibrium monetary growth rate and the associated inflation tax is thus, affected by the intensity of context contingent factors. Concentrating only on Markov strategies in this repeated game shows that the Markov perfect equilibrium features maximum inflation tax.

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Bibliographic Info

Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2011-20.

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Length: 27 pages
Date of creation: Oct 2011
Date of revision:
Handle: RePEc:uct:uconnp:2011-20

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Keywords: Endogenous monetary policy; Leviathan; central bank; inflation tax; money search;

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  1. Fernando M. Martin, 2010. "Government Policy in Monetary Economies," Discussion Papers dp10-01, Department of Economics, Simon Fraser University.
  2. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  3. Fernando Martin, 2009. "A Positive Theory of Government Debt," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 608-631, October.
  4. Vasco Cúrdia & Michael Woodford, 2009. "Conventional and unconventional monetary policy," Staff Reports 404, Federal Reserve Bank of New York.
  5. Aleksander Berentsen & Guillaume Rocheteau & Shouyong Shi, . "Friedman Meets Hosios: Efficiency in Search Models of Money," IEW - Working Papers 154, Institute for Empirical Research in Economics - University of Zurich.
  6. Chow, Gregory C., 1997. "Dynamic Economics: Optimization by the Lagrange Method," OUP Catalogue, Oxford University Press, number 9780195101928, September.
  7. Benjamin Lester & Andrew Postlewaite & Randall Wright, 2008. "Information, Liquidity and Asset Prices," PIER Working Paper Archive 08-039, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  8. Araujo, Luis & Camargo, Braz, 2008. "Endogenous supply of fiat money," Journal of Economic Theory, Elsevier, vol. 142(1), pages 48-72, September.
  9. Cem Karayalcin, 2005. "Divided We Stand, United We Fall: The Hume-Weber-Jones Mechanism for the Rise of Europe," Working Papers 0509, Florida International University, Department of Economics.
  10. Berentsen, Aleksander, 2006. "On the private provision of fiat currency," European Economic Review, Elsevier, vol. 50(7), pages 1683-1698, October.
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Cited by:
  1. Parag Waknis, 2011. "Monetary Policy under Leviathan Currency Competition," Working papers 2011-21, University of Connecticut, Department of Economics.
  2. Parag, Waknis, 2012. "Political economy of sub-national spending in India," MPRA Paper 36813, University Library of Munich, Germany.

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