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We investigate the extent to which monetary policy can enhance the functioning of the private credit system. Specifically, we characterize the optimal return on money in the presence of credit arrangements. 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. We consider a (nonlinear) monetary mechanism that is designed to enhance the credit system. An active monetary policy is sufficient for relaxing credit constraints. Finally, we characterize the optimal monetary policy and show that it necessarily entails a positive inflation rate.

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We analyze how trading in secondary markets for public debt change the inherent links between monetary and fiscal policy, by studying both inflation and debt dynamics. When agents do not trade in these markets, there exists a unique steady state and traditional passive/active policy prescriptions are useful in delivering determinate equilibria. In contrast, when agents trade in secondary markets and bonds are scarce, there exist a liquidity premium on public debt and bonds affect inflation dynamics and vice versa. Then, in a monetary equilibrium, the government budget constraint can be satisfied for different combinations of inflation and debt. Thus, self-fulfilling beliefs that deliver multiple steady states are possible. Moreover, traditional passive/active policy prescriptions are not always useful in delivering determinate equilibria. However, monetary and fiscal policies can be used as an equilibrium selection device. We find that, with a low inflation target, active monetary policies are more likely to deliver real and nominal determinacy and further amplify the effectiveness of these policies in reducing steady state inflation.