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Endogenous Monetary Policy: A Leviathan Central Bank in a Lagos-Wright Economy

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  • Parag Waknis

    (University of Connecticut and University of Massachusetts Dartmouth)

Abstract

This paper studies the nature of optimal monetary policy under a Leviathan monetary authority in a microfounded model of money based on ?. Such a monetary authority is a reality whenever and wherever fiscal policy is a primary driver of the monetary policy. Under no commitment, we characterize and solve for a Markov perfect equilibrium as well as for equilibrium with reputation concerns. For the Markov equilibrium, a generalized Euler equation is derived to characterize optimal policy that trades off the current benefit of increasing consumption against the reduced ability to do so in the future. Under reputation equilibrium, centralized market interaction is modeled as an infinitely repeated game of perfect monitoring, between a Leviathan monetary authority (a large player) and the economic agents (small players). Such a game has multiple equilibriums but the large-small player dynamics pins down the equilibrium set of payoffs and features less than maximum inflation tax. Depending on how we interpret the Leviathan central bank, the factors determining the realized equilibrium differ. Higher fiscal profligacy of the underlying political authority leads to a higher monetary growth rate and inflation tax, while existence of threat of competition in case of a private money supplier or threat of external aggression in case of a self interested sovereign leads to a lower one. The realized equilibrium monetary growth rate and the associated inflation tax is thus, affected by the intensity of context contingent factors. Concentrating only on Markov strategies in this repeated game shows that the Markov perfect equilibrium features maximum inflation tax.

Suggested Citation

  • Parag Waknis, 2011. "Endogenous Monetary Policy: A Leviathan Central Bank in a Lagos-Wright Economy," Working papers 2011-20, University of Connecticut, Department of Economics.
  • Handle: RePEc:uct:uconnp:2011-20
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    References listed on IDEAS

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    1. Fernando Martin, 2009. "A Positive Theory of Government Debt," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 608-631, October.
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    3. Cem Karayalçin, 2008. "Divided We Stand, United We Fall: The Hume-North-Jones Mechanism For The Rise Of Europe," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 49(3), pages 973-997, August.
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    5. Fernando M. Martin, 2013. "Government Policy In Monetary Economies," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 54(1), pages 185-217, February.
    6. Aleksander Berentsen & Guillaume Rocheteau & Shouyong Shi, 2007. "Friedman Meets Hosios: Efficiency in Search Models of Money," Economic Journal, Royal Economic Society, vol. 117(516), pages 174-195, January.
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    8. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
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    Cited by:

    1. Parag Waknis, 2011. "Monetary Policy under Leviathan Currency Competition," Working papers 2011-21, University of Connecticut, Department of Economics.
    2. Parag, Waknis, 2012. "Political economy of sub-national spending in India," MPRA Paper 36813, University Library of Munich, Germany.

    More about this item

    Keywords

    Endogenous monetary policy; Leviathan; central bank; inflation tax; money search;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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