Outside versus Inside Bonds

Abstract

When agents are liquidity constrained, two options exist-borrow or sell assets. We compare the welfare properties of these options in two economies: in one, agents can borrow (issue inside bonds) and in the other they can sell government bonds (outside bonds). All transactions are voluntary, implying no taxation or forced redemption of private debt. We show that any allocation in the economy with inside bonds can be replicated in the economy with outside bonds and that the converse is not true. Moreover, under best policies, the allocation with outside bonds strictly Pareto dominates the allocation with inside bonds.

Wealth Distribution, Inflation Tax, and Societal Benefits of Illiquid Bonds

“…Not surprisingly, the steady‐state outcomes are almost identical in the two economies. This is consistent with the findings in Kocherlakota (2003), Boel and Camera (2006), and Berentsen and Waller (2007).…”

“…The real allocation of this economy is almost identical to that of the money‐only economy because bonds are nearly perfect substitutes for money. This is consistent with the findings in Kocherlakota (2003), Boel and Camera (2006), and Berentsen and Waller (2007). If bonds are sufficiently liquid and their discount rate is high enough, again money is not held.…”

“…In our numerical examples, the consumption‐equivalent welfare cost of the money‐only steady state relative to the optimal steady state is approximately 0.8%∼ 1.2% of the average consumption in the money‐only steady state. These results complement those of Aiyagari, Wallace, and Wright (1996), Kocherlakota (2003), Boel and Camera (2006), and Berentsen and Waller (2007) that rationalize the social desirability of illiquid bonds. Much more striking here is that the societal benefits of illiquid bonds are derived from the commonly observed feature in modern economies: the nondegenerate distribution of monetary wealth that is subject to the inflation tax.…”

Government Policy in Monetary Economies

“…The government only actively participates in the night market, i.e., taxes are levied on hours worked at night, and open market operations are conducted in the night market. As in Aruoba and Chugh (2010), Berentsen and Waller (2008), and Martin (2011), public bonds are book entries in the government's record. Since bonds are not physical objects and the government does not participate in the day market (i.e., cannot intermediate or provide third-party verification), bonds are not used as a medium of exchange in the day market and, thus, money is essential.…”

“…Next, I consider three specific variants of the underlying monetary economy: "Competitive markets" assumes all markets are perfectly competitive; "financial intermediation" assumes the existence of a technology that records financial (but not goods) transactions, which allows for the intermediation of fiat money, as in Berentsen et al (2007); and "trading frictions" assumes decentralized exchange in some markets and introduces an inefficiency due to bargaining over the terms of trade. The set of model variants considered here, although not exhaustive, is fairly representative of the type of micro-founded monetary economies we would adopt to study the determination of government policy.…”