Adverse Selection, Segmented Markets, and the Role of Monetary Policy∗

A model is constructed in which trading partners are asymmetrically informed about future trading opportunties and where spatial and informational frictions limit arbitrage between markets. These frictions create an inefficiency relative to a full information equilibrium, and the extent of this inefficiency is affected by monetary policy. Under some conditions a Friedman rule is optimal, but if financial market integration is limited and if the central bank can intervene in only some markets, then there is a deviation from the Friedman rule. ∗The authors thank participants at the Cleveland Fed Money Workshop 2007, the Midwest Macroeconomics Meetings 2008, and our colleagues at Washington University in St. Louis for helpful comments and suggestions. Sanches thanks the Center for Research in Economics and Strategy at Washington University for financial support.