Efficient Monetary Allocations and the Illiquidity of Bonds
30 Pages Posted: 23 Dec 2014
Date Written: July 2006
Abstract
We construct a monetary economy with heterogeneity in discounting and consumption risk. Agents can insure against this risk with money and nominal government bonds, but all trades must be monetary. We demonstrate that a deflationary policy à la Friedman cannot sustain the constrained efficient allocation as no-arbitrage imposes too stringent a bound on the return money can pay. The constrained-efficient allocation can be sustained when bonds have positive yields and, under certain conditions, only if they are illiquid. Illiquidity, meaning that bonds cannot be transformed into consumption as easily as cash, is necessary to eliminate arbitrage opportunities due to disparities in shadow interest rates.
Keywords: Money, Heterogeneity, Friedman Rule, Illiquidity
JEL Classification: E4, E5
Suggested Citation: Suggested Citation
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