Outside Versus Inside Bonds

When agents are liquidity constrained, two options exist — borrow or sell assets. We compare the welfare properties of these options in two economies: in one, agents can borrow (issue inside bonds) and in the other they can sell government bonds (outside bonds). All transactions are voluntary, implying no taxation or forced redemption of private debt. We show that any allocation in the economy with inside bonds can be replicated in the economy with outside bonds and that the converse is not true. Moreover, under best policies, the allocation with outside bonds strictly Pareto dominates the allocation with inside bonds. JEL-Code: E4, E5 Key-Words: Liquidity, Financial markets, Monetary policy, Search ∗The paper has benefitted from comments by Narayana Kocherlakota, Neil Wallace, RandyWright and participants at several seminar and conference presentations. We thank the Federal Reserve Bank of Cleveland, and the Kellogg Institute at the University of Notre Dame for research support.