Abstract :
This study investigates an incomplete markets economy in which the saving behavior of a
continuum of infinitely lived agents is influenced by precautionary saving motives and
borrowing constraints. Agents can use two types of assets (interest bearing IOUS and money)
to smooth consumption. Money is valued because of a timing friction in the bond market. In
particular, the bond market closes before agents observe their idiosyncratic productivity
shock. I find that the Friedman rule is not optimal for this economy. The results indicate that
the optimal allocation has a rate of inflation of 10%, and a positive amount of private credit
held by the government. A positive inflation rate transfers resources from agents with big
endowments to those holding bonds which improves risksharing, and therefore, welfare.
However, for higher rates of inflation, agents economize on money holdings, offsetting the
insurance effects, and causing a reduction in welfare. Furthermore, higher rates of inflation
discourage agents from borrowing, and the endogenous lower bound on bond holdings ishigher than the exogenous borrowing limit. High rates of inflation, therefore, exacerbate
frictions in the bond market.
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