There is a dual role for credit: It allows buyers to trade without fiat money and also permits them to borrow against future income. However, not all traders have access to credit. As a result, there is a social role for fiat money because it allows agents to self-insure against the risk of not being able to use credit in some transactions. The authors consider a (nonlinear) monetary mechanism that is designed to enhance the credit system. An active monetary policy is sufficient for relaxing credit constraints. Finally, they characterize the optimal monetary policy and show that it necessarily entails a positive inflation rate, which is required to induce cooperation in the credit system.
Optimal Monetary Policy in a Model of Money and Credit
WP 11-28 - The authors investigate the extent to which monetary policy can enhance the functioning of the private credit system. Specifically, they characterize the optimal return on money in the presence of credit arrangements.