Optimal Fiscal and Monetary Policy in A Baumol-Tobin Model
When the government uses bonds to smooth tax distortions agents must use bonds to smooth consumption. This is not efficient because smoothing by bonds requires more real resources than smoothing by money. At the social optimum only money is used. This can be achieved by contracting a monetary aggregate which includes government deposits at the central bank, at a constant rate. Unlike models which allow a costless trip to the asset market at the beginning of each period, here the rate of change in the monetary base fluctuates over time.