Optimal monetary and fiscal policies in a search theoretic model of monetary exchange

Search models of monetary exchange commonly assume that terms of trade in anonymous markets are determined via Nash bargaining, which generally causes monetary equilibrium to be inefficient. Bargaining frictions add to the classical intertemporal distortion present in most monetary models, whereby agents work today to obtain cash that can be used only in future transactions. In this paper, we study the properties of optimal fiscal and monetary policy within the framework of Lagos and Wright (2005). We show that fiscal policy can be implemented to alleviate underproduction while money is still essential. If lump sum monetary transfers are available, a production subsidy can restore the efficiency of monetary equilibria. The Friedman rule belongs to the optimal policy set, but higher inflation rates are also possible. When lump-sum monetary transfers are not available, equilibrium allocations are generally not first-best. Nevertheless, fiscal policy still results in substantial welfare gains. Money can be extracted from circulation via a sales tax on decentralized market activities, and the Friedman rule is only optimal if the buyer has relatively low bargaining power.     

Search, money, and inflation under private information

I study monetary exchange and inflation when buyers have private information about their willingness to pay for certain goods. Introducing imperfect information in the Lagos-Wright [A unified framework for monetary theory and policy analysis, J. Polit. Economy 113(3) (2005) 463-484] economy shows that the existence of monetary equilibrium is a more robust feature of the environment. In general, my model has a monetary steady state in which only a proportion of the agents hold money. Agents who do not hold money cannot participate in trade in the decentralized market. The proportion of agents holding money is endogenous and depends (negatively) on the level of expected inflation. As in Lagos and Wright's model, in equilibrium there is a positive welfare cost of expected inflation, but the origins of this cost are very different.     

Macroeconomic fluctuations and bargaining

I study the limit rule for bilateral bargaining when agents recognize that the aggregate economy (and thus the match surplus) follows a finite-state Poisson process. The rule derived in this paper is of special importance for decentralized exchange economies with bargaining. Two simple applications are presented to illustrate this fact. The first example is a model of wage bargaining and trade externalities. I show that in such situations sophisticated bargaining tends to increase the volatility of the wage bill. The second example is based on the Kiyotaki-Wright model of money. I explain how equilibrium prices depend in a fundamental way on the dynamic bargaining solution.     

Mises and the moderns on the inessentiality of money in equilibrium

The challenge of rendering monetary exchange intelligible within a Walrasian general equilibrium framework is well known. Perhaps less well known is the difficulty of integrating monetary and exchange economies in decentralized conceptions of equilibrium, of which the evenly rotating economy of Ludwig von Mises (1949) is an early example. After reviewing the prospect for money in the evenly rotating economy, I survey the modern literature on frictions that make money useful for exchange. While exploring techniques commonly used to generate a useful role for money in this environment, I make a distinction between exchange frictions and epistemic frictions. Although theoretical efforts have largely focused on exchange frictions, recent experimental evidence suggests that epistemic frictions warrant further attention. I conclude that Mises should be seen as a pioneer in this literature, though recent advances demonstrate that the set of frictions capable of rendering money useful is much larger than he envisioned.     

NOMINAL BONDS AND INTEREST RATES*

In this article, I integrate the microfoundation of monetary theory with the model of limited participation to analyze the competition between nominal bonds and money. The market for government nominal bonds is centralized and Walrasian, whereas the goods market is modeled as random matches. The government imposes a legal restriction that requires all government goods to be purchased with money but not with bonds. By contrast, private agents can exchange between themselves with both money and bonds. I show that an arbitrarily small legal restriction is sufficient to prevent matured bonds from being a medium of exchange. I also analyze the effects of monetary policy with and without the legal restriction. Some of those effects differ significantly from traditional monetary models.     

An overlapping-generations model with search

Search is embedded in an overlapping-generations model. The young participate in a centralized market, and then are matched in pairs in a decentralized market. The old only participate in the centralized market. If the buyer's bargaining power in pairwise trade is close to unity and if the old are risk averse, then the golden-rule rate of money transfer is positive. Such risk aversion, the pairwise meetings, and dependence of the young's saving on the rate of return are necessary for this result.     

Sharing Money Creation in a Monetary Union*

How to share money creation among the members of the European Monetary Union? To address this issue, we construct a two‐country New Open‐economy Macroeconomics model of an asymmetric monetary union with an incomplete financial market and home bias in consumption. We consider two sharing rules consistent with the current regulations of the European System of Central Banks. First, each participating National Central Bank supplies half of the European Central Bank determined money creation in the monetary union. Secondly, each National Central Bank adapts the national increase in money demand, under the constraint that the total money creation in the union does not exceed the level determined by the ECB for the whole union. We show that the current sharing rule, which ignores countries’ heterogeneity, is superior in terms of welfare. The key role of the current account is emphasized. It proves an efficient decentralized mechanism for allocation of money.     

The effectiveness of monetary policy in steering money market rates during the financial crisis

The financial crisis has deeply affected money markets and thus, potentially, the proper functioning of the interest rate channel of monetary policy transmission. Therefore, we analyze the effectiveness of monetary policy in steering euro area money market rates by looking at (i) the predictability of money market rates on the basis of monetary policy expectations and (ii) the impact of extraordinary central bank measures on money market rates. We find that during the crisis money market rates up to 12 months still respond to revisions in the expected path of future rates, even though to a lesser extent than before August 2007. We attribute part of the loss in monetary policy effectiveness to money market rates being driven by higher liquidity premia and increased uncertainty about future interest rates. Our results also indicate that the ECB’s non-standard monetary policy measures as of October 2008 were effective in addressing the disruptions in the euro area money market. In fact, our estimates suggest that non-standard monetary policy measures helped to lower Euribor rates by more than 80 basis points. These findings show that central banks have effective tools at hand to conduct monetary policy in times of crises.     

WEALTH,ASSET PORTFOLIO,MONEY DEMAND AND POLICY RULE

I look at the linkages between monetary policy and asset wealth using quarterly data for the USA. I show that a positive interest rate shock leads to a fall in aggregate wealth and an important change in portfolio composition: housing wealth gradually decreases, but the effects are very persistent; and financial wealth quickly shrinks, but the impact is short‐lived. I also find that the money market can be characterized as follows: (i) the money demand has a large interest elasticity and a small output elasticity; and (ii) the estimated monetary policy reaction function highlights the special focus given by the central bank to developments in monetary aggregates. These features call for an approach whereby monetary authorities put more emphasis on tracking wealth developments, in particular, given the asset portfolio rebalancing between money holdings and financial and/or housing assets.     

Bargains,Barter, and Money

We examine a search money model in which there is a symmetric coincidence of wants in all barter matches. However, when bargaining outcomes are asymmetric across matches, the barter economy is inefficient. Then a robust monetary equilibrium exists provided that money holders enjoy adequate bargaining terms. Fiat money may be welfare improving. In contrast to the literature, it is the asymmetry in bargains across matches rather than asymmetry in demands that generates these results. Journal of Economic Literature Classification Numbers: C78, E40.     

Industry-Level Wage Bargaining: A Partial Rehabilitation—The German Experience

In order to reduce unemployment, it is often recommended that industry-level wage bargaining in Germany should be replaced by a more decentralized system. This paper provides a critical assessment of the current wage bargaining institutions and re-examines the case for a more decentralized system. Based on a theoretical model integrating Insider–Outsider aspects into the comparison, the uniformly superior employment performance of a decentralized wage bargaining system is questioned. We conclude that, rather than solely trying to decentralize wage bargaining, a promising policy option may be to improve the skills of the unemployed by efficient labour market policies and to foster institutional reforms such that wage bargaining takes account of the long-run employment consequences of wage setting.     

Whither Monetary Economics?

I argue that monetary economics should be pursued by applying implementation theory to models which contain explicit frictions that make money essential. The argument has two parts. First, I argue that models in which real balances are assumed to be productive—models with money in utility or production functions or with cash-in-advance constraints—contain hidden inconsistencies. Second, I argue that the approach advocated is capable of providing new insights about some of the main issues in monetary economics: the effects of monetary shocks, the welfare cost of inflation, and the roles of inside and outside money.     

NOMINAL WAGE INDEXATION,QUASI‐EQUILIBRIA AND REAL WAGE DYNAMICS

In contrast to the traditional static approach to indexation, this paper analyses the dynamic consequences for real wages of the mechanism that links nominal wages to inflation. Revisiting a contribution by Dehez and Fitoussi on macroeconomic fluctuations , I analyse a monetary overlapping generations small open economy in which full indexation is interpreted as the occurrence of a dynamic ‘quasi‐equilibrium’. In the suggested framework, the nominal wage is linked to the inflation rate by a specific indexation formula whose shape relies on unions' bargaining positions. Assuming a constant peg for the real interest rate and the superneutrality of money, I show that the economy has a unique long‐run quasi‐equilibrium allocation whose stability depends only on the behaviour of the monetary authority. Moreover, I show how the operating of a ‘wage‐aspiration effect’ might lead to the persistence of involuntary unemployment.     

An optimal monetary policy in an aggregate neoclassical model of economic growth

This paper shows that the usual Ramsey-Cass-Koopmans optimal-growth theory is applicable to decentralized monetary economies and illustrates, with a simple model, how optimal growth can be achieved via a simple monetary policy. Securities and the endogeneity aspect of the money supply are explicitly introduced. This paper shows that the steady state under optimal growth is a saddle point, that the dynamic behavior of the capital-labor ratio and real per capita consumption is identical to that found in the usual literature in which money is not introduced, and that the optimal monetary policy is “counter-cyclical.”     

The impact of Chinese monetary policy on co-movements between money and capital markets

From 2010 to 2017, with interest rate liberalization and capital market development in China, the impact of monetary policies on China’s financial markets underwent continuous evolution. Using the DCC-GARCH model, this study investigates the transmission process of monetary policies from the money market to capital markets (stock and bond markets). The results show that in the early stage the instability of the money and stock markets and the downturn in the bond market are primarily caused by the block of monetary policy transmission and the paucity of fund sources in the capital markets. Subsequently, the outbreak of the 2013 money shortage and the 2015 stock market crash are also closely related to monetary policies. In the later periods, the money and stock markets maintain a low degree of correlation for a long time, reducing the impact of destabilizing factors on the stock market. By contrast, with the advancement of interest rate reform and the optimization of bond market structure, the bond market is highly relevant to the money market. The central bank regulates the bond market more effectively using both traditional and innovative monetary policy tools.     

A monetary theory with non-degenerate distributions

We construct and analyze a tractable search model of money with a non-degenerate distribution of money holdings. Analytical tractability comes from modeling decentralized exchange as directed search, which makes the monetary steady state block recursive. By adapting lattice-theoretic techniques, we characterize individuals? policy and value functions, and show that these functions satisfy the standard conditions of optimization. We prove that a unique monetary steady state exists and provide conditions under which the steady-state distribution of buyers over money balances is non-degenerate. Moreover, we analyze the properties of this distribution.     

Disequilibrium macroeconomics, money as a buffer stock and the estimation of money demand

Standard explanations of the seeming instability of the money demand in the post-1973 period usually link to stories about financial innovation and deregulation. I propose an alternative hypothesis: Much of the seeming instability occurs because of shifts in monetary policy, either explicit or implicit, in an environment where the Federal Reserve controls a more “exogenous” money stock. My econometric analysis modifies existing methods for estimating markets in disequilibrium and incorporates newly developed cointegration and error-correction modeling. My findings provide support for the buffer-stock interpretation of the money market.     

A Search Model of Unemployment and Inflation*

This paper introduces money into the standard labor‐matching model. A double‐coincidence problem makes money necessary as a medium of exchange. In the long run, a rise in the growth rate of money leads to higher inflation and higher unemployment, such that the long‐run Phillips curve is not vertical. The optimal monetary growth rate decreases with greater worker bargaining power, the level of unemployment benefits, and the payroll tax rate.     

Endogenous uncertainty and the non-neutrality of money

Summary. We study some implications of the Theory of Rational Beliefs to monetary policy. We show that monetary policy in a Rational Beliefs environment can have an important effect on the characteristics of economic fluctuations. In Rational Beliefs Equilibria money is generically non-neutral unlike Rational Expectations Equilibria in which money is neutral and monetary policy is ineffective. Under Rational Beliefs Equilibria nominal prices and real output change not only in response to changes in the exogenous growth rate of money but also in response to changes in the state of beliefs. In Rational Beliefs Equilibria monetary shocks have real effects even when they are observed but are not fully anticipated. Furthermore, the non-neutrality of money results in a short run Phillips curve. When money “flutters, real output sputters” [8]. We show that Endogenous Uncertainty and the distribution of market beliefs are the major explanatory variables of such fluctuations. Under Rational Expectations monetary policy is ineffective because agents neutralize it by predicting correctly the effect of the policy. Under Rational Beliefs it is shown instead that inflation and recessions can be substantially aggravated by the distribution of market beliefs. Received: January 14, 2002; revised version: April 5, 2002 RID="*" ID="*" I would like to thank Mordecai Kurz for his constant help and support. Most of the ideas developed hereby have been inspired by innumerable and fruitful discussions with him. I have also greatly benefited from helpful comments by Stanley Black, Luigi Campiglio, Carsten Nielsen and Ho-Mou Wu. I also received valuable remarks from participants at the V meeting of “The Society for the Advancement of Economic Theory” held in Ischia, Italy, on July 2-8, 2001, where an initial draft of the present work was presented.     

Profit sharing as entry deterrence mechanism

In a right-to-manage framework, this paper analyzes the optimal choice of the pay scheme (profit sharing vs. fixed wage) in a unionized duopoly with potential market entry and decentralized bargaining. The paper shows that, depending on the institutional features, both pay systems can arise as equilibria in Nash strategies. Under duopoly with committed bargaining, the fixed wage is the Nash equilibrium; with flexible bargaining, an agreement between the incumbent firm and its union about profit sharing arises as Nash equilibrium, if the union is not too strong. A monopoly with threat of entry reinforces the selection of profit sharing as a deterrent mechanism.