Dynamic monetary equilibrium with a Non-Observed Economy and Shapley and Shubik's price mechanism

We build a general equilibrium model with inside and outside money, heterogeneous tax-evading households, a government and a central bank to demonstrate the dynamic nature of the relationship between inflation rates as a monetary policy and the size of the Non-Observed Economy. Using Shapley and Shubik's (1977) price mechanism, we show that fiat money has a positive value in a unique monetary equilibrium where formal and informal markets coexist. In this model, with forward-looking agents and a government that has long term budget constraint, inflation is not only a tax but is also a debt, revealing yet another interpretation of the Ricardian effect. The model is capable of producing both positive and negative relationships between the change in the inflation rate and the size of the Non-Observed Economy, both over time and across countries. In this setting, the Non-Observed Economy plays a role of a “friction”, allowing monetary policy to have real effects, as commodity allocation between government and private consumption depends on the inflation path.