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Casmef Seminars - Liquidity Market and Optimal Monetary Policy in a New Monetarist Framework

16 February 2016 at 1:00 PM - 2:00 PM

Room A411, Campus on Viale Romania, 32

Speaker: Ugo Zannini, LUISS

Abstract: The article investigates the optimality of the Friedman rule for government debt in a micro-founded model of money and risk-free bonds. A stylized trading friction makes bonds illiquid for consumption to a fraction of agents and gives a Pareto-improving role to asset reallocation. To this purpose I model a competitive liquidity market.

When the Friedman rule can be applied to money then, as it is standard, applying the rule to both instruments is optimal. The novel result is that, when the Friedman rule cannot be applied to money, the presence of a liquidity market makes the Friedman rule sub-optimal for bonds. The liquidity market tends to equalize the marginal return on money (consumption) and bond (saving) of agents with illiquid bonds. At the Friedman rule consumption inequality between agents with liquid and illiquid bonds is maximized, with the former group consuming efficiently. A lower interest rate, via the liquidity market, increases the return on money in equilibrium, hence consumption inequality shrinks and social welfare rises. To switch from the low-welfare (high interest) to the high-welfare (moderate interest) equilibrium, the authority must increase the relative supply of money.