Outside versus inside bonds: A Modigliani-Miller type result for liquidity constrained economies

When agents are liquidity constrained, two options exist –sell assets or borrow. We compare the allocations arising in two economies: in one, agents can sell government bonds (outside bonds) and in the other they can borrow (issue inside 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 but that the converse is not true. However, the optimal policy in each economy makes the allocations equivalent. JEL-Code: E4, E5 Key-Words: Liquidity, Financial markets, Monetary policy, Search The paper has bene…tted from comments by the Editor, two anonymous referees, David Andolfatto, Narayana Kocherlakota, Neil Wallace, Randy Wright and participants at several seminar and conference presentations. We thank the Federal Reserve Bank of Chicago, the Federal Reserve Bank of St.Louis, the Kellogg Institute at the University of Notre Dame and the Swiss National Science Foundation for research support.