Bargaining and the Value of Money

Abstract

Search models of monetary exchange have typically relied on Nash (1950) bargaining or strategic games that yield an equivalent outcome to determine the terms of trade. By considering alternative axiomatic bargaining solutions in a simple search model with divisible money, we show how this choice matters for important results such as the ability of the optimal monetary policy to generate an efficient allocation. We show that the quantities traded in bilateral matches are always inefficiently low under the Nash (1950) and Kalai-Smorodinsky (1975) solutions, whereas under strongly monotonic solutions such as the egalitarian solution (Luce and Raiffa, 1957; Kalai, 1977), the Friedman Rule achieves the first best allocation. We evaluate quantitatively the welfare cost of inflation under the different bargaining solutions, and we extend the model to allow for endogenous market composition.