The Nature of Money in a Convertible Currency World

In a world where the means of exchange is convertible into the numeraire consumption good at a fixed rate, no one wants to hold money over time – and due to convertibility there is no means by which the Friedman rule can generate deflation. This is the environment we study in this paper in order to demonstrate that there is still a way to reach the first-best: institutionalize the naked shorting of the unit of account, or in other words establish a banking system. To motivate the benefits of a banking system, the environment has real productivity shocks that are constantly changing the optimal level of economic activity, so the optimal quantity of money is inherently stochastic. Efficiency in such an environment requires the capacity to expand the money supply on an “as needed” basis. We show how a debt-based payments system that relies on banks to certify the individual debtors’ IOUs addresses the monetary problem. This model explains (i) central bank monetary policy as a means of stabilizing the banking system and (ii) usury laws as means of promoting equilibria that favor non-banks over those that favor banks. Furthermore, by modeling a commercial bank-based monetary system as an efficient solution to a payments problem this paper develops a theoretic framework that may be used to evaluate central bank digital currency proposals.

Time-inconsistent discounting and the Friedman rule: roles of non-unitary discounting

We examine the optimality of the Friedman rule by considering recent development of behavioral economics. We construct a simple macroeconomic model where agents discount consumption and leisure at different rates. We also consider a standard exponential discounting model and a hyperbolic discounting model, by assuming that the same discounting applies to both consumption and leisure. Money is introduced via a cash-in-advance constraint. Although the three models are observationally equivalent, they provide different policy implications. The Friedman rule is optimal in the latter two models, while it is not optimal in the first model if agents discount consumption is at a higher rate than leisure.

Risk Premia and the Real Effects of Money

This paper proposes a flexible-price theory of the role of money in an economy with incomplete idiosyncratic risk sharing. When the risk premium goes up, money provides a safe store of value that prevents interest rates from falling, reducing investment. Investment is too high during booms when risk is low, and too low during slumps when risk is high. Monetary policy cannot correct this: money is superneutral and Ricardian equivalence holds. The optimal allocation requires the Friedman rule and a tax/subsidy on capital. The real effects of money survive even in the cashless limit. (JEL E32, E41, E43, E44, E52)

Optimal fiscal and monetary policy under different fiscal instruments

PurposeThe paper includes characterizing Ramsey policy in a cash-in-advance monetary model, under flexible and sticky prices, and with different fiscal instruments.Design/methodology/approachThe paper analytically and numerically characterizes the dynamic properties of Ramsey allocations. The author computes dynamics by solving second-order approximations to the Ramsey planner’s policy functions around a non-stochastic Ramsey steady state.FindingsThe Friedman rule is not mainly optimal in a cash-in-advance model with distorting taxes. The Ramsey-optimal policy with both taxes on income and consumption calls for a high inflation rate that is extremely volatile, despite the fact that changing prices is costly.Practical implicationsThe optimality of zero nominal interest rate under flexible prices in monetary models is not mainly the case and quite depends on the preferences. The optimality of a zero inflation rate under sticky prices also very much depends on the assumed set of fiscal instruments.Originality/valueThe non-optimality of the Friedman rule under flexible prices is quite new. Moreover, studying the optimal fiscal and monetary policy in a New Keynesian model with a rich set of fiscal instruments is also quite original.

OPTIMAL MONETARY AND FISCAL POLICY IN A CURRENCY UNION WITH FRICTIONAL GOODS MARKETS

We develop an open economy model of a currency union with frictional goods markets and endogenous search decisions to study optimal monetary and fiscal policy. Households finance consumption with a common currency and can search for locally produced goods across regions that differ in their market characteristics. Equilibrium is generically inefficient due to regional spillovers from endogenous search decisions. While monetary policy alone cannot correct this distortion, fiscal policy can help improve allocations by taxing or subsidizing production at the regional level. When households of only one region can search, optimal policy entails a deviation from the Friedman rule and a production subsidy (tax) if there is underinvestment (overinvestment) in search decisions. Optimal policy when households from both region search requires the Friedman rule and zero production taxes in both regions.

OVERCOMING FINANCIAL FRICTIONS WITH THE FRIEDMAN RULE

A general equilibrium model with financial frictions in which individuals may encounter unobservable investment opportunities is developed along the lines of Kiyotaki and Moore (2012). I study efficiency properties induced by money and monetary policy when financial frictions prevent optimal equilibrium allocations. By providing closed-form solutions to all prices, allocations, welfare, and, especially, the distribution of individuals with respect to assets, I show that the Friedman rule achieves maximal social welfare, independent of how tight the financial constraints may be. The same level of welfare would be induced by an omniscient central planner able to verify who has an investment opportunity.