Limited Commitment and the Legal Restrictions Theory of the Demand for Money

This paper addresses the "rate of return" puzzle of monetary theory. Similarly to the legal restrictions theory of the demand for money, we assume that Government bonds are subject to a minimum purchase requirement. Differently from this theory, however, we assume that intermediaries, when issuing private notes, cannot commit to always redeem them. First, we study an environment with legal restrictions to intermediation and show that cash and interest bearing bonds both circulate in the economy. Then, we drop the legal restrictions and show that also with active intermediation, under limited commitment, there is an equilibrium with rate of return dominance. A positive interest rate provides the intermediaries with the incentive to issue and redeem their notes.