Two papers on monetary theory where the Friedman Rule is not optimal

Nominal Contracts and the Payment System

By Hakime Tomura

This paper introduces into an overlapping generations model the courts inability to distinguish different qualities of goods of the same kind. Given the recognizability of fiat money for the court, this friction leads to the use of nominal debt contracts as well as the use of fiat money as a means of payment in the goods market. This result holds without dynamic inefficiency or lack of double coincidence of wants. Instead, money is necessary because it is essential for credit. However, there can occur a shortage of real money balances for liability settlements, even if the money supply follows a Friedman rule. This problem can be resolved if the central bank can lend fiat money to agents elastically at a zero intraday interest rate within each period. Given the economy being dynamically efficient, this policy makes the money supply cease to be the nominal anchor for the price level. In this case, the monetary steady state becomes compatible with other nominal anchors than the money supply.

Liquidity Premium, Credit Costs, and Optimal Monetary Policy

By Sukjoon Lee

I study how monetary policy affects firms’ external financing decisions. More precisely, I study the transmission mechanism of monetary policy to credit costs in a general equilibrium macroeconomic model where firms issue corporate bonds or obtain bank loans, and corporate bonds are not just stores of value but also serve a liquidity role. The model shows that an increase in the nominal policy rate can lower the borrowing cost in the corporate bond market, while increasing that in the bank loan market, and I provide empirical evidence that supports this result. The model also predicts that a higher nominal policy rate induces firms to substitute corporate bonds for bank loans, which is supported by the existing empirical evidence. In the model, the Friedman rule is suboptimal so that keeping the cost of holding liquidity at a positive level is socially optimal. The optimal policy rate is an increasing function of the degree of corporate bond liquidity.

By chance, two interesting papers about monetary policy and the Friedman Rule in this week’s NEP-DGE report. Monetary theory is quite dizzying as small details can lead to dramatically different results. The details can be about what money actually is, how it is used, how credit is collateralized, etc. This is fascinating, but also difficult to keep up. Policy advice is so difficult, yet important.

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