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Friedman Meets Hosios: Efficiency in Search Models of Money

  • Aleksander Berentsen
  • Guillaume Rocheteau
  • Shouyong Shi

In this paper we study the inefficiencies of the monetary equilibrium and optimal monetary policies in a search economy. We show that the same frictions that give fiat money a positive value generate an inefficient quantity of goods in each trade and an inefficient number of trades (or search decisions). The Friedman rule eliminates the first inefficiency and the Hosios rule the second. A monetary equilibrium attains the social optimum if and only if both rules are satisfied. When the two rules cannot be satisfied simultaneously, which occurs in a large set of economies, optimal monetary policy achieves only the second best. We analyze when the second-best monetary policy exceeds the Friedman rule and when it obeys the Friedman rule. Furthermore, we extend the analysis to an economy with barter and show how the Hosios rule must be modified in order to internalize all search externalities.

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File URL: http://www.economics.utoronto.ca/public/workingPapers/UT-ECIPA-SHOUYONG-02-04.pdf
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Paper provided by University of Toronto, Department of Economics in its series Working Papers with number shouyong-02-04.

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Length: 34 pages
Date of creation: 11 Jul 2002
Date of revision:
Handle: RePEc:tor:tecipa:shouyong-02-04
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  18. Miquel Faig, 2001. "A Search Theory of Money and Commerce with Neoclassical Production," Working Papers faig-01-01, University of Toronto, Department of Economics.
  19. Allen Head & Shouyong Shi, 2000. "A Fundamental Theory of Exchange Rates and Direct Currency Trades," Working Papers 993, Queen's University, Department of Economics.
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