Econometric Society, 8th World Congress, Seattle, August 2000. A Quantitative General Equilibrium Analysis. University of Iowa, Dept. of Economics, Tow Lecture Series, October 2000. University of Iowa Manuscript, submitted to the Journal of Monetary Economics. A Quantitative General Equilibrium Analysis.
Money is valued because of a timing friction in the bond market.
In particular, the bond market closes before agents observe their idiosyncratic productivity shock. High inflation rates transfer resources from agents with high endowments to those holding bonds, which can increase welfare. However, in an inflationary environment, agents economize on money holdings, causing a reduction in welfare. Furthermore, different monetary growth rates imply different revenues for the government. The level of revenues generated by inflation determines the interest rate on government bonds, and the effective borrowing constraint for agents.