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Monetary Search, Proportional Transaction Costs, and the Currency Equivalent Index

AIER Sound Money Project Working Paper No. 2018–02

22 Pages Posted: 2 Oct 2017 Last revised: 8 Jan 2018

Joshua R. Hendrickson

University of Mississippi; American Institute for Economic Research

Date Written: January 2, 2018

Abstract

Determining the correct monetary aggregate to use is (or at least should be) an important consideration when taking any monetary model to the data. In this paper I present a basic monetary search model with two assets, currency and bonds. I assume that in order for assets to be used in trade, they require some verification that the asset is authentic. Some fraction of the assets are destroyed in the verification process. This suggests that when both assets circulate in equilibrium, the appropriate monetary aggregate is a linearly homogeneous function with the weights of each asset determined by its degree of liquidity. When one normalizes the degree of liquidity of currency to 1, this implies that the appropriate monetary aggregate is the Currency Equivalent Index proposed by Rotemberg, Driscoll, and Poterba (1995). One advantage of this result is that researchers can construct a monetary aggregate that is exactly applicable to the model. Finally, I show that it is only permissible to use simple sum monetary aggregates when all assets offer the same liquidity properties or the central bank conducts policy according to the Friedman Rule.

Keywords: Money, Monetary Search, Monetary Aggregation, Currency Equivalent

JEL Classification: E40, E51

Suggested Citation

Hendrickson, Joshua R., Monetary Search, Proportional Transaction Costs, and the Currency Equivalent Index (January 2, 2018). AIER Sound Money Project Working Paper No. 2018–02. Available at SSRN: https://ssrn.com/abstract=3045307

Joshua R. Hendrickson (Contact Author)

University of Mississippi ( email )

Oxford, MS 38677
United States

American Institute for Economic Research

PO Box 1000
Great Barrington, MA 01230
United States

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