Monetary and fiscal policies in a search and matching model with endogenous growth

Search and matching frictions on financial and labor markets are introduced in a dynamic general equilibrium framework, affecting the dynamics of capital and employment adjustments. While prices are fully flexible and determined by money supply, money demand arises endogenously from financial market matching frictions that prevent some deposits from being channeled into productive investment. This allows monetary policy to affect household’s portfolio decisions with repercussions on steady state output and employment growth. In particular, an optimal, growth maximizing inflation rate is shown to exist when financial market liquidity affects the steady state rate of capital accumulation balancing the portfolio shift induced by a higher inflation rate with an overall lower rate of return on total wealth. In addition, fiscal policy is shown to be growth-enhancing to the extent that it helps to overcome some of the externality problems that search frictions create by providing additional assets on the financial market. Finally, the paper explores the interaction between monetary and fiscal policies showing that monetary policy can reinforce the positive effects of fiscal policy.