Nominal Bonds and Interest Rates: Liquidity and Welfare

In this paper I analyze how interest rates, output and welfare depend on the liquidity of nominal bonds. The model features limited participation in the bonds market and decentral-ized exchanges (search) in the goods market. In a fraction of trades in the goods market, a legal restriction forbids the use of bonds as the means of payments. I show that nominal bonds can become illiquid endogenously when tastes are strong for the goods in the restricted trades. When such tastes are not very strong, bonds are liquid and the yield curve is nega-tively sloped, but bonds may or may not be perfect substitutes for money. As the coverage of the legal restriction increases, welfare first decreases and then increases, but eliminating the legal restriction altogether increases welfare. I also compare economies with exogenous degrees of bonds ’ liquidity. Completely illiquid bonds can yield higher welfare and higher nominal interest rates than liquid bonds. However, between two economies in which bonds have interior degrees of liquidity, it is possible that welfare is higher when bonds are more liquid, that welfare is higher when the nominal interest rate is lower, and that the interest rate is higher when bonds are more liquid