Optimal Monetary and Fiscal Policies in a Search Theoretic Model of Monetary Exchange.Unpublished working paper

We study optimal monetary and fiscal policies, and the welfare costs of inflation, within the framework of Lagos and Wright (2005). We show how proportional production subsidies and sales taxes associated to trades in decentralized markets can be implemented to alleviate underproduction due to bargaining inefficiencies, while money is still essential. When the government has zero expenditures and negative lump sum money transfers are available, we find multiple combinations of taxes, subsidies and (sometimes strictly positive) nominal interest rates that restore the efficiency of monetary equilibrium allocations. When negative lump sum transfers are not available, the optimality of Friedman rule crucially depends on the bargaining power of the buyer, and equilibria are not first best. With positive government expenditures, the optimal policy must trade-off inflation and production tax distortions. In all these cases, deviations from the Friedman rule may be large, and there are considerable welfare gains of having fiscal and monetary policies in place. Holding fiscal policies constant, the welfare costs of increasing inflation may be as high as 8 % of lifetime consumption