Friedman Meets - osios / 011 iciency in Search Models o 1 Money

In this paper we study the ine!ciencies of the monetary equilibrium and optimal monetary policies in a search economy. We show that the same frictions that give !at money a positive value generate an ine!cient quantity of goods in each trade and an ine!cient number of trades (or search decisions). The Friedman rule eliminates the !rst ine!ciency and the Hosios rule the second. A monetary equilibrium attains the social optimum if and only if both rules are satis!ed. When the two rules cannot be satis!ed simultaneously, which occurs in a large set of economies, optimal monetary policy achieves only the second best. We analyze when the second-best monetary policy exceeds the Friedman rule and when it obeys the Friedman rule. Furthermore, we extend the analysis to an economy with barter and show how the Hosios rule must be modi!ed in order to internalize all search externalities. 8ey9ords : Money, Search, Friedman rule, Hosios rule. Aleksander Berentsen: University of Basel, Economics Department (WWZ), Petersgraben 51, Postfach, 4003 Basel, Switzerland (email: [email protected]). Guillaume Rocheteau: Copland Building, School of Economics, Australian National University, Canberra ACT 0200, Australia (email: [email protected]). Shouyong Shi: Department of Economics, University of Toronto, 150 St. George Street, Toronto, Ontario, Canada, M5S 3G7 (email: [email protected]). This paper has been presented at Canadian Macroeconomic Study Group meeting (Vancouver, 2001), the Conference on Monetary Economics at the Federal Reserve Bank of Cleveland (2001), Australian National University (2001), and the Society for Economic Dynamics meeting (New York, 2002). We have received useful comments from the participants of these conferences and workshops. We are especially grateful to Ricardo Lagos, Matthew Ryan, and Randall Wright for their comments. Shi would like to acknowledge the Social Sciences and Humanities Research Council of Canada for !nancial support. All remaining errors are ours alone.