LIQUIDITY PREFERENCE AND FINANCIAL INTERMEDIATION

We examine the characteristics of optimal monetary policies in a gener al equilibrium model with incomplete markets. Markets are incomplete b ecause of uninsured preference uncertainty, and because productive cap ital is traded infrequently. Rational individuals are willing to hold a liquid asset-''money''-at a premium. Monetary policy interacts with existing financial institutions to determine this premium, as well as the level of precautionary holdings. We show that inflation is expansi onary, and that the optimal inflation rate is positive if there is no operative banking system (the Tobin effect). Otherwise, efficiency req uires that money be undominated in its rate of return (the Friedman Ru le).