Optimal monetary policy and default

Sandra Lizarazo and Jose-Maria Da-Rocha

MPRA Paper from University Library of Munich, Germany

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.

Keywords: Default; Inflation; Fiat Money; Friedman rule; Endogenous Borrowing Constraints; Precautionary Savings. (search for similar items in EconPapers)
JEL-codes: E21 E41 E44 E52 (search for similar items in EconPapers)
Date: 2011-06-29
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:31931

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