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On the Coexistence of Money and Bonds

  • Political Science


govbonds.dvi On the Coexistence of Money and Bonds∗ David Andolfatto Simon Fraser University October 2004 Abstract Preliminary 1 Introduction The question addressed in this paper concerns a phenomenon that, on the sur- face at least, appears to defy a simple no-arbitrage principle. That is, con- sider two securities, each of which is issued by the government. One security represents a risk-free claim against itself, called ‘money.’ The other security represents a risk-free claim against money, called ‘bonds.’ In an unfettered fi- nancial market, theory suggests that one of two things should happen: [1] that the rates of return on these two securities should be equated, if they are to be willingly held in the wealth portfolios of individuals; or [2] that the higher return asset should drive the lower return asset out of circulation. As is well known, this stark prediction appears to be inconsistent with the rate of return differential that normally exists between money and bonds. This discrepancy between theory and facts is known as the coexistence puzzle. The common explanation for the coexistence puzzle is that money is a ‘spe- cial’ type of asset. In particular, money provides nonpecuniary ‘liquidity’ ser- vices that makes it a preferred method of payment relative to other types of assets. This is the basic idea behind any model that generates a demand for money by assuming that money enters into the utility (or shopping time) func- tion or by assuming that some purchases are subject to a cash-in-advance con- straint. While these ‘short-cut’ methods have their uses, they are ill-suited for the question at hand since they basically assume away the coexistence puzzle. Here, I take the view that any satisfactory explanation should be couched in terms of a model with a physical environment that renders money essential for trade; e.g., see Kocherlakota (1998). ∗I have benefited from conversations with Gabriele Camera, Bruce Champ, Steve Easton, Angela Redish, Shouyong Shi, Davi

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