Understanding the Roles of Money, or When is the Friedman Rule Optimal, and Why?

Abstract

In this paper, we study the optimal steady state monetary policy in overlapping generations (OG) models. In contrast to economies populated by infinitely-lived representative agents (ILRA), the Friedman Rule is frequently not the policy that maximizes the welfare of two-period lived consumers. Our principal goal is to understand why the Friedman Rule is suboptimal in OG economies. To this end, we construct a mechanism-specifically, a monetary policy regime-that renders money useless in the sense of executing intergenerational transfers. Under this governmental regime, we show that the optimal monetary policy is the Friedman Rule. Our finding is robust to alternative rationales for valued fiat money; specifically, whether money is held voluntarily or involuntarily.