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

  • Pere Gomis-Porqueras
  • Adrian Peralta-Alva

In this paper we study optimal monetary and fiscal policies, and the welfare costs of inflation, within the Lagos and Wright (2005) framework. Monetary equilibria may be inefficient without fiscal policy tools due to bargaining frictions. We show that subsidies in decentralized markets can be implemented to alleviate underproduction, while money is still essential. Deviations from the Friedman rule may be large, and having fiscal and monetary policies in place results in considerable welfare gains. When fiscal policies are held constant, the welfare costs of increasing inflation may be as high as 8% of lifetime consumption. When lump sum monetary transfers are not available, a positive production subsidy may be inflationary and welfare reducing. However, sales taxes in the decentralized market and production taxes in the centralized market may increase welfare. The optimality of the Friedman rule in this case depends crucially on the bargaining power of the buyer, and equilibria are not first best.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2008-015.

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Date of creation: 2008
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Handle: RePEc:fip:fedlwp:2008-015
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  1. 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.
  2. Andolfatto, David, 2007. "Essential Interest-Bearing Money," MPRA Paper 4780, University Library of Munich, Germany.
  3. Joydeep Bhattacharya & Joseph H. Haslag & Antoine Martin, 2004. "Heterogeneity, redistribution, and the Friedman rule," Research Working Paper RWP 04-01, Federal Reserve Bank of Kansas City.
  4. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report 346, Federal Reserve Bank of Minneapolis.
  5. Nobuhiro Kiyotaki & Randall Wright, 1989. "A contribution to the pure theory of money," Staff Report 123, Federal Reserve Bank of Minneapolis.
  6. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  7. 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.
  8. 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.
  9. Andolfatto, David, 2008. "Essential Interest-Bearing Money (2008)," MPRA Paper 8565, University Library of Munich, Germany.
  10. Alberto Trejos & Randall Wright, 1993. "Search, bargaining, money and prices: recent results and policy implications," Proceedings, Federal Reserve Bank of Cleveland, pages 558-584.
  11. Guillaume Rocheteau & Christopher Waller, 2005. "Bargaining and the value of money," Working Paper 0501, Federal Reserve Bank of Cleveland.
  12. George S. Tolley, 1957. "Providing for Growth of the Money Supply," Journal of Political Economy, University of Chicago Press, vol. 65, pages 465.
  13. 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.
  14. 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.
  15. Kalai, Ehud & Smorodinsky, Meir, 1975. "Other Solutions to Nash's Bargaining Problem," Econometrica, Econometric Society, vol. 43(3), pages 513-18, May.
  16. 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.
  17. 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.
  18. Chae, Suchan, 2002. "Tax incidence with bargaining," Economics Letters, Elsevier, vol. 77(2), pages 199-204, October.
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