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Optimal monetary and fiscal policies in a search theoretic model of monetary exchange

  • Gomis-Porqueras, Pedro
  • Peralta-Alva, Adrian

Search models of monetary exchange commonly assume that terms of trade in anonymous markets are determined via Nash bargaining, which generally causes monetary equilibrium to be inefficient. Bargaining frictions add to the classical intertemporal distortion present in most monetary models, whereby agents work today to obtain cash that can be used only in future transactions. In this paper, we study the properties of optimal fiscal and monetary policy within the framework of Lagos and Wright (2005). We show that fiscal policy can be implemented to alleviate underproduction while money is still essential. If lump sum monetary transfers are available, a production subsidy can restore the efficiency of monetary equilibria. The Friedman rule belongs to the optimal policy set, but higher inflation rates are also possible. When lump-sum monetary transfers are not available, equilibrium allocations are generally not first-best. Nevertheless, fiscal policy still results in substantial welfare gains. Money can be extracted from circulation via a sales tax on decentralized market activities, and the Friedman rule is only optimal if the buyer has relatively low bargaining power.

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Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 54 (2010)
Issue (Month): 3 (April)
Pages: 331-344

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Handle: RePEc:eee:eecrev:v:54:y:2010:i:3:p:331-344
Contact details of provider: Web page: http://www.elsevier.com/locate/eer

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  1. David Andolfatto, 2009. "Essential interest-bearing money," Working Papers 2009-044, Federal Reserve Bank of St. Louis.
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  11. Narayana R. Kocherlakota, 2005. "Optimal monetary policy: what we know and what we don’t know," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Oct, pages 10-19.
  12. Chae, Suchan, 2002. "Tax incidence with bargaining," Economics Letters, Elsevier, vol. 77(2), pages 199-204, October.
  13. Kiyotaki, Nobuhiro & Wright, Randall, 1991. "A contribution to the pure theory of money," Journal of Economic Theory, Elsevier, vol. 53(2), pages 215-235, April.
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  17. Andolfatto, David, 2008. "Essential Interest-Bearing Money (2008)," MPRA Paper 8565, University Library of Munich, Germany.
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