On the Limitations of Monetary Policy
59 Pages Posted: 7 Nov 2011
Date Written: November 7, 2011
This paper argues that in a homogeneous monetary Real Business Cycle economy where a complete set of nominal contingent claims exist, the requirement to collateralize loans, alone, does not affect the equilibrium allocation when monetary policy is chosen optimally: the Pareto optimal allocation can be supported. Rather, it is the presence of additional inefficiencies such as market incompleteness or heterogeneity of agents that limits the ability of optimal monetary policy, and more precisely, inflation, to support the first best allocation. In our model policy is non-Ricardian or equivalently outside money exists, and the Central Bank trades only in short-term nominally risk-free bonds: as a consequence monetary policy that sets rates of interest and accommodates money demand effectively determines the allocation of prices at equilibrium. A Friedman rule (r=0), which would be optimal in the absence of collateral constraints, here it is not: at the resulting prices collateral constraints bind. A path of prices that avoids binding collateral constraints necessarily involves a non-zero interest rate. The path of prices that supports the Pareto optimal allocation occurs when the collateral constraint binds: a positive inflation tax on money balances is efficient. For interest rates that permit the collateral constraint to bind, a policy of stable inflation (alternatively, money growth) implies that the collateral constraint binds after a sequence of positive (respectively negative) productivity shocks followed by a negative (respectively positive) productivity shock.
Keywords: monetary policy, inflation, collateral
JEL Classification: E13, E22, E41, E44, E52, E61
Suggested Citation: Suggested Citation