Working Paper

Welfare-enhancing inflation and liquidity premia

Abstract: The Friedman rule recommends eliminating liquidity premia on nominally risk-free government debt and following a deflationary monetary policy. The desirability of this prescription in a broad class of monetary models contrasts sharply with observation. In reality, the average rate of inflation is almost always positive and long-dated government securities are–as a matter of policy–allowed to trade at a discount relative to cash, even when these securities represent risk-free claims to cash. Our paper identifies a set of empirically-plausible conditions under which a strictly positive inflation and liquidity premium on long-dated government securities are both necessary to improve economic welfare. These conditions include: heterogeneous time-preferences, idiosyncratic risk over the timing of expenditure opportunities, and incomplete insurance markets. Our paper provides yet another rationale for a strictly positive inflation target and the use of penalty rates at central bank lending facilities.

Keywords: Friedman rule; liquidity; inflation; term premium;

JEL Classification: E4; E5;

https://doi.org/10.20955/wp.2023.001

Status: Published in Review of Economic Dynamics

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2023-01

Number: 2023-001

Note: Publisher DOI: https://doi.org/10.1016/j.red.2023.09.007

Related Works

• Working Paper Revision: Welfare-enhancing inflation and liquidity premia