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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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File URL: http://www.krannert.purdue.edu/programs/phd/Working-paper-series/Year-2004/1171.pdf
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Paper provided by Purdue University, Department of Economics in its series Purdue University Economics Working Papers with number 1171.

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Length: 28 pages
Date of creation: Nov 2004
Date of revision:
Handle: RePEc:pur:prukra:1171
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  8. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers 930, Queen's University, Department of Economics.
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  20. Beatrix Paal & Bruce D. Smith, 2013. "The sub-optimality of the Friedman rule and the optimum quantity of money," Annals of Economics and Finance, Society for AEF, vol. 14(2), pages 911-948, November.
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