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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. Chow, Gregory C., 1997. "Dynamic Economics: Optimization by the Lagrange Method," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780195101928, October.
  3. Araujo, Luis & Camargo, Braz, 2008. "Endogenous supply of fiat money," Journal of Economic Theory, Elsevier, vol. 142(1), pages 48-72, September.
  4. Fernando M. Martin, 2004. "A Positive Theory of Government Debt," Macroeconomics, EconWPA 0408013, EconWPA, revised 12 Oct 2004.
  5. 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.
  6. Aleksander Berentsen & Guillaume Rocheteau & Shouyong Shi, 2004. "Friedman meets Hosios: efficiency in search models of money," Working Paper 0408, Federal Reserve Bank of Cleveland.
  7. Vasco Curdia & Michael Woodford, 2010. "Conventional and Unconventional Monetary Policy," Discussion Papers, Columbia University, Department of Economics 0910-17, Columbia University, Department of Economics.
  8. Berentsen, Aleksander, 2006. "On the private provision of fiat currency," European Economic Review, Elsevier, vol. 50(7), pages 1683-1698, October.
  9. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers, Queen's University, Department of Economics 930, Queen's University, Department of Economics.
  10. 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.
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Cited by:
  1. Parag, Waknis, 2012. "Political economy of sub-national spending in India," MPRA Paper 52807, University Library of Munich, Germany, revised Apr 2013.
  2. Parag Waknis, 2011. "Monetary Policy under Leviathan Currency Competition," Working papers, University of Connecticut, Department of Economics 2011-21, University of Connecticut, Department of Economics.

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