Kocherlakota (2003) presents an example of a monetary economy where
efficiency is enhanced with the introduction of a nominally risk-free bond
that is specifically designed to be illiquid. In his environment, an asset
market involving swaps of money for bonds effects a socially desirable redistribution
of purchasing power that might otherwise be replicated by a
policy of type-contingent money transfers.
In this paper, I recast Kocherlakota’s model in a fully dynamic quasilinear
model and characterize optimal interventions when type-contingent
transfers are feasible and when they are not. When they are not, an
illiquid bond is essential. However, I also find that an illiquid bond may
remain essential even when type-contingent transfers are feasible.
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