Optimal policy in an economy with human capital where money is essential

- Lagos and Wright (2005) model is extended to incorporate human capital.
- The monetary policy alone cannot achieve the first-best optimum.
- Subsidies to human capital investment are required.
- The Friedman rule is still optimal.

This paper investigates optimal policies in an economy with human capital where money is essential in trades of consumption goods. To this end, we extend the Lagos and Wright (2005) economy to incorporate human capital accumulation. (i) Since human capital accumulation is distorted by search friction as well as bargaining friction, monetary policy alone cannot achieve the first-best allocation. In our preferred setting, (ii) subsidies to human capital investment are required for the first-best optimum. (iii) The Friedman rule is still optimal.