Monetary Search, Proportional Transaction Costs, and the Currency Equivalent Index

Abstract

Determining the correct monetary aggregate to use is (or at least should be) an important consideration when taking any monetary model to the data. In this paper I present a basic monetary search model with two assets, currency and bonds. I assume that in order for assets to be used in trade, they require some verification that the asset is authentic. Some fraction of the assets are destroyed in the verification process. This suggests that when both assets circulate in equilibrium, the appropriate monetary aggregate is a linearly homogeneous function with the weights of each asset determined by its degree of liquidity. When one normalizes the degree of liquidity of currency to 1, this implies that the appropriate monetary aggregate is the Currency Equivalent Index proposed by Rotemberg, Driscoll, and Poterba (1995). One advantage of this result is that researchers can construct a monetary aggregate that is exactly applicable to the model. Finally, I show that it is only permissible to use simple sum monetary aggregates when all assets offer the same liquidity properties or the central bank conducts policy according to the Friedman Rule.