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Efficient monetary allocations and the illiquidity of bonds

  • Boel, Paola
  • Camera, Gabriele

We construct a monetary economy with heterogeneity in discounting and consumption risk. Agents can insure against this risk with both money and nominal government bonds, but all trades must be monetized. We demonstrate that a deflationary policy a la Friedman cannot sustain the efficient allocation. The reason is that no-arbitrage imposes a stringent bound on the return money can pay. The efficient allocation can be sustained when bonds have positive yields and – under certain conditions – only if they are illiquid. Illiquidity – meaning bonds cannot be transformed into consumption as efficiently as cash – is necessary to eliminate arbitrage opportunities.

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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 53 (2006)
Issue (Month): 7 (October)
Pages: 1693-1715

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Handle: RePEc:eee:moneco:v:53:y:2006:i:7:p:1693-1715
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