Societal Benefits of Nominal Bonds

In this paper, I provide a possible explanation of why nominally risk-free bonds are essential in monetary economies. I argue that the role of nominal bonds is to serve as record-keeping devices in intertemporal exchanges of money. I show that bonds can only serve this role if they are illiquid (costly to exchange for goods). Finally, I show that in economies in which nominal bonds are essential, welfare and nominal interest rates are both positively associated with the supply of illiquid bonds (if that supply is small). ∗ Previous versions of this paper circulated under the title, “Optimal Co-existence of Money and Nominal Bonds. ” I thank Dean Corbae and Barbara McCutcheon for their comments. I also thank the participants in seminars at the Banco de Portugal, CEMFI, and the 2000 Conference on Advances in Monetary Theory and Payment Systems for their comments. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. 1