Elastic Money, Inflation, And Interest Rate Policy

Abstract

This paper studies optimal monetary policy in an environment in which aggregate liquidity shocks affect individual agents asymmetrically and exchange may be conducted using either bank deposits (inside money) or fiat currency (outside money). A central monetary authority controls the stock of outside money and chooses the inflation rate optimally. It also pursues an interest rate policy that affects the rate at which private banks create inside money. We find that both components of monetary policy are necessary to maximize social welfare. By controlling interest rates the monetary authority can affect the price level and adjust the consumption of agents, thus providing insurance against unfavorable liquidity shocks. The feasibility of the interest rate policy requires a minimum rate of trend inflation that may be positive and in principle quite large. The paper thus links two principal components of monetary policy: the optimal interest rate policy and the optimal long-run inflation rate.