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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. Randall Wright, 2005. "Introduction to "Models of Monetary Economies II: The Next Generation"," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Oct, pages 2-9.
  2. Tai-wei Hu & John Kennan & Neil Wallace, 2007. "Coalition-Proof Trade and the Friedman Rule in the Lagos-Wright Model," NBER Working Papers 13310, National Bureau of Economic Research, Inc.
  3. David Andolfatto, 2009. "Essential interest-bearing money," Working Papers 2009-044, Federal Reserve Bank of St. Louis.
  4. Guillaume Rocheteau & Christopher Waller, 2005. "Bargaining and the value of money," Working Paper 0501, Federal Reserve Bank of Cleveland.
  5. George S. Tolley, 1957. "Providing for Growth of the Money Supply," Journal of Political Economy, University of Chicago Press, vol. 65, pages 465.
  6. Nobuhiro Kiyotaki & Randall Wright, 1989. "A contribution to the pure theory of money," Staff Report 123, Federal Reserve Bank of Minneapolis.
  7. Joydeep Bhattacharya & Joseph H. Haslag & Antoine Martin, 2005. "Heterogeneity, Redistribution, And The Friedman Rule," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 437-454, 05.
  8. Ritter Moritz, 2010. "The Optimum Quantity of Money Revisited: Distortionary Taxation in a Search Model of Money," The B.E. Journal of Macroeconomics, De Gruyter, vol. 10(1), pages 1-26, June.
  9. Alberto Trejos & Randall Wright, 1993. "Search, bargaining, money and prices: recent results and policy implications," Proceedings, Federal Reserve Bank of Cleveland, pages 558-584.
  10. Narayana R. Kocherlakota, 2005. "Optimal Monetary Policy: What We Know And What We Don'T Know," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 715-729, 05.
  11. Deviatov Alexei & Wallace Neil, 2001. "Another Example in which Lump-sum Money Creation is Beneficial," The B.E. Journal of Macroeconomics, De Gruyter, vol. 1(1), pages 1-22, February.
  12. Chae, Suchan, 2002. "Tax incidence with bargaining," Economics Letters, Elsevier, vol. 77(2), pages 199-204, October.
  13. Andolfatto, David, 2008. "Essential Interest-Bearing Money (2008)," MPRA Paper 8565, University Library of Munich, Germany.
  14. Kalai, Ehud & Smorodinsky, Meir, 1975. "Other Solutions to Nash's Bargaining Problem," Econometrica, Econometric Society, vol. 43(3), pages 513-18, May.
  15. Miguel Molico, 2006. "The Distribution Of Money And Prices In Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 47(3), pages 701-722, 08.
  16. Ricardo Lagos & Randall Wright, 2002. "A unified framework for monetary theory and policy analysis," Working Paper 0211, Federal Reserve Bank of Cleveland.
  17. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  18. Scott Freeman & Joseph H. Haslag, 1995. "Should bank reserves earn interest?," Economic and Financial Policy Review, Federal Reserve Bank of Dallas, issue Q IV, pages 25-33.
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