A model of optimal legal restrictions and open market operations

This paper considers an asset model that generates a monetary equilibrium in which capital, government bonds, and fiat money are held as perfect substitutes. Due to a congestion effect, output per producer is a decreasing function of the aggregate capital stock, and this effect makes a legal restriction on capital accumulation welfare enhancing. The restriction considered is that the money to capital ratio must be at some level greater than that level existing in a monetary equilibrium. In this context an open market purchase of bonds will decrease the nominal interest rate, and inflation, but may increase or decrease the real interest rate. I also show that the optimal policy response to an exogenous increase in total factor productivity is for the monetary authority to undertake an open market purchase. The two changes together result in a decrease in inflation and the nominal interest rate, and an increase in the real interest rate.