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

  • Pedro 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
Date of revision:
Handle: RePEc:fip:fedlwp:2008-015
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  1. David Andolfatto, 2008. "Essential Interest-Bearing Money," EIEF Working Papers Series 0802, Einaudi Institute for Economics and Finance (EIEF), revised Oct 2008.
  2. Moritz Ritter, 2010. "The Optimum Quantity of Money Revisited: Distortionary Taxation in a Search Model of Money," DETU Working Papers 1005, Department of Economics, Temple University.
  3. Trejos, Alberto & Wright, Randall, 1993. "Search, Bargaining, Money and Prices: Recent Results and Policy Implications," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 25(3), pages 558-76, August.
  4. Tai-wei Hu & John Kennan & Neil Wallace, 2009. "Coalition-Proof Trade and the Friedman Rule in the Lagos-Wright Model," Journal of Political Economy, University of Chicago Press, vol. 117(1), pages 116-137, 02.
  5. Nobuhiro Kiyotaki & Randall Wright, 1989. "A contribution to the pure theory of money," Staff Report 123, Federal Reserve Bank of Minneapolis.
  6. Kalai, Ehud & Smorodinsky, Meir, 1975. "Other Solutions to Nash's Bargaining Problem," Econometrica, Econometric Society, vol. 43(3), pages 513-18, May.
  7. 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.
  8. 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.
  9. Randall Wright, 2005. "Introduction To "Models Of Monetary Economies Ii: The Next Generation"," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 305-316, 05.
  10. Guillaume Rocheteau & Christopher J. Waller, 2005. "Bargaining and the value of money," Working Paper 0501, Federal Reserve Bank of Cleveland.
  11. Andolfatto, David, 2008. "Essential Interest-Bearing Money (2008)," MPRA Paper 8565, University Library of Munich, Germany.
  12. Ricardo Lagos & Randall Wright, 2002. "A unified framework for monetary theory and policy analysis," Working Paper 0211, Federal Reserve Bank of Cleveland.
  13. Chae, Suchan, 2002. "Tax incidence with bargaining," Economics Letters, Elsevier, vol. 77(2), pages 199-204, October.
  14. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  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. 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.
  17. George S. Tolley, 1957. "Providing for Growth of the Money Supply," Journal of Political Economy, University of Chicago Press, vol. 65, pages 465.
  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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