Bonds with transactions service and optimal Ramsey policy

Abstract

We introduce a model of government bonds with transactions services into a standard dynamic stochastic general equilibrium sticky-price monetary economy. This additional feature results in an endogenous interest-rate spread and affects equilibrium allocations and inflation by altering the Ramsey planner's sequence of implementability and sticky-price constraints. Qualitatively, the trade-off confronting a planner in sticky-price models shown in recent literature, between using inflation surprise and labor-income tax, is eliminated by the liquid bond channel. We find that the more sticky prices become, the more the optimal fiscal-monetary policy stabilizes prices and also creates less distortionary and less volatile income taxes by taxing the liquidity service of bonds. Quantitatively, we show that the additional tax instrument created by the bond liquidity channel can yield a sizable welfare gain from an economy without this channel. Show more