Optimal monetary policy and default

Lizarazo, Sandra and Da-Rocha, Jose-Maria (2011): Optimal monetary policy and default.

Abstract

In a context in which individuals might default on their debts and subsequently be excluded from credit markets, holding money helps agents smooth their consumption during periods in which they cannot borrow. Therefore holding money makes the punishment to default less severe. In this context, by affecting money demand, monetary policy can affect incentives to default; determining optimal monetary policy can then be thought of as equivalent to choosing the optimal default rate. Since each economy might have a different optimal default rate, each economy might have a different optimal monetary policy different from the Friedman rule. Specifically, we compare the US to Colombia, using a model with idiosyncratic labor income risk and fiat money. Given differences in enforcement of debt contracts, and differences in income variability and persistence, we find that high inflation is costlier for developing countries compared to developed countries.

• Item Type: MPRA Paper
• Language: English
• Keywords: Default, Inflation, Fiat Money, Friedman rule, Endogenous Borrowing Constraints, Precautionary Savings.
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E21 - Consumption ; Saving ; Wealth; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E41 - Demand for Money

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