On the Optimal Quantity of Liquid Bonds

Abstract

We develop a dynamic general equilibrium model to analyze the optimal quantity of liquid bonds by investigating the following three questions: Under what conditions is it socially desirable to contract the bond supply, what incentive problems are mitigated by doing this, and how large are the effects? We show that reducing the bond supply induces agents to increase their demand for money, which can enhance welfare by improving the allocation of the medium of exchange. However, this effect fails for high inflation rates, because agents hold so little money in the first place that manipulating the bond supply is not enough to correct the misallocation.

Keywords: Monetary theory, over-the-counter markets, bond supply, financial intermediation, money demand, pecuniary externality

JEL Classification: D52, D62, E31, E40, E50, G11, G12, G28