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We construct a monetary economy with heterogeneity in discounting and consumption risk. Agents can insure against this risk with money and nominal government bonds, but all trades must be monetary. We demonstrate that a deflationary policy a la Friedman cannot sustain the constrained-efficient allocation as no-arbitrage imposes too stringent a bound on the return money can pay. The constrained-efficient allocation can be sustained when bonds have positive yields and, under certain conditions, only if they are illiquid. Illiquidity, meaning that bonds cannot be transformed into consumption as easily as cash, is necessary to eliminate arbitrage opportunities due to disparities in shadow interest rates.


NOTICE: this is the author’s version of a work that was accepted for publication in Journal of Monetary Economics. Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in Journal of Monetary Economics, volume 53, issue 7 (2006). DOI: 10.1016/j.jmoneco.2006.02.002

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