Elastic Money, Inflation, and Interest Rate Policy

Optimal monetary policy is studied in an environment in which money plays an essential role in facilitating exchange and aggregate shocks affect individual agents asymmetrically. Exchange may be conducted using either bank deposits (inside money) or fiat currency (outside money). A central monetary authority both controls the stock of outside money and pursues an interest rate policy that affects the rate at which private banks create inside money. We find that the optimal monetary policy requires management of both interest rates and the quantity of outside money. By controlling interest rates the monetary authority can affect the price level in the short-run and adjust households' consumption, thus providing insurance against unfavorable aggregate shocks. The feasibility of the interest rate policy requires a minimum rate of trend inflation that may be positive and in principle quite large. The paper thus links two principal components of monetary policy: the optimal interest rate policy and the optimal long-run inflation rate.