Optimal Monetary and Fiscal Policies in a Search Theoretic Model of Monetary Exchange

Abstract

In this paper we study optimal monetary and fiscal policies, and the welfare costs of inflation, within the Lagos and Wright (2005) framework. Monetary equilibria may be inefficient without fiscal policy tools due to bargaining frictions. We show that subsidies in decentralized markets can be implemented to alleviate underproduction, while money is still essential. Deviations from the Friedman rule may be large, and having fiscal and monetary policies in place results in considerable welfare gains. When fiscal policies are held constant, the welfare costs of increasing inflation may be as high as 8% of lifetime consumption. When lump sum monetary transfers are not available, a positive production subsidy may be inflationary and welfare reducing. However, sales taxes in the decentralized market and production taxes in the centralized market may increase welfare. The optimality of the Friedman rule in this case depends crucially on the bargaining power of the buyer, and equilibria are not first best.