Optimal monetary policy: distribution efficiency versus production efficiency

This paper investigates the tradeoff between distribution effect and production effect of monetary policy when there exist unobservable idiosyncratic liquidity shocks. In the absence of risksharing arrangements such as a credit market, monetary policy serves to provide <fr>ex post</fr> insurance to smooth consumption. Specifically, issuing interestbearing bonds restores credit transactions on money through bondmoney exchanges. Such a policy has a positive distribution effect, but the resulting inflation hampers production efficiency. It is demonstrated that the tradeoff between distribution efficiency gain and production efficiency loss would result in net welfare enhancement if consumers are relativeriskaverse enough.