The rate-of-return-dominance puzzle asks why low-return assets, like fiat money, are used in actual economies given that risk-free higher-return assets are available. As long as this question remains unresolved, most conclusions from monetary models which arbitrarily restrict the marketability properties of alternative assets to make money valuable are difficult to assess. In this paper, I provide a framework in which fiat money has value in equilibrium, even though a higher-return asset is available and there are neither restrictions nor transaction costs in using it. I suggest that the use of money is associated with frictions underlying debt contracts. In an environment where full enforcement is not feasible, the actual rate of return on assets is determined by incentives eliciting voluntary debt repayment. I show that the inflation rate or, more generally, the depreciation rate of an asset in which debts are denominated may function as a commitment device. As a result, money is used in equilibrium and the optimal inflation rate is positive.
Classification JEL : E41, E50, E51
Keywords : Money, Inflation, Debt Enforcement, Banking
Updated on: 06/12/2018 10:56