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Optimal Monetary Policy in an Economy with Incomplete Markets and Idiosyncratic Shocks

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  • Ahmet Akyol

    (University of Iowa)

Abstract

This study investigates an incomplete markets economy in which the saving behavior of a continuum of infinitely lived agents is influenced by precautionary saving motives and borrowing constraints. Two types of assets (interest bearing IOUs and money) enhance the liquidity of agents by providing an additional means of smoothing consumption and by effectively loosening borrowing constraints. Money is valued because of a timing friction in the bond market. In particular, the bond market closes before agents observe their idiosyncratic productivity shock. High inflation rates will transfer resources from agents with high endowments to those holding bonds which can increase welfare. However, in an inflationary environment, agents economize on money holdings, causing a reduction in welfare. Furthermore, different monetary growth rates will imply different seigniorage revenues for government. The level of seigniorage revenues will determine the interest rate on government bonds, and the effective borrowing constraint. This study quantitatively examines the welfare implications of different monetary growth rates. Initial results indicate that higher inflation rates increase welfare.

Suggested Citation

  • Ahmet Akyol, 2000. "Optimal Monetary Policy in an Economy with Incomplete Markets and Idiosyncratic Shocks," Econometric Society World Congress 2000 Contributed Papers 0796, Econometric Society.
    • Handle: RePEc:ecm:wc2000:0796
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    References listed on IDEAS

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    1. Thomas J. Sargent & Neil Wallace, 1984. "Some Unpleasant Monetarist Arithmetic," Palgrave Macmillan Books, in: Brian Griffiths & Geoffrey E. Wood (ed.), Monetarism in the United Kingdom, pages 15-41, Palgrave Macmillan.
    2. Woodford, Michael, 1990. "The optimum quantity of money," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 2, chapter 20, pages 1067-1152, Elsevier.
    3. Per Krusell & Anthony A. Smith, Jr., 1999. "On the Welfare Effects of Eliminating Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(1), pages 245-272, January.
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    Cited by:

    1. Campanale, Claudio & Fugazza, Carolina & Gomes, Francisco, 2015. "Life-cycle portfolio choice with liquid and illiquid financial assets," Journal of Monetary Economics, Elsevier, vol. 71(C), pages 67-83.
    2. Francesco Lippi & Nicholas Trachter, 2011. "The optimum Quantity of Money with Borrowing Constraints," EIEF Working Papers Series 1108, Einaudi Institute for Economics and Finance (EIEF), revised Apr 2011.
    3. Nils M. Gornemann & Keith Kuester & Makoto Nakajima, 2012. "Monetary policy with heterogeneous agents," Working Papers 12-21, Federal Reserve Bank of Philadelphia.
    4. Lizarazo, Sandra & Da-Rocha, Jose-Maria, 2011. "Optimal monetary policy and default," MPRA Paper 31931, University Library of Munich, Germany.

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