Working paper 220 was presented at The Economic Consequences of Government Deficits: an Economic Policy Conference, cosponsored by the Center for the Study of American Business and the Institute of Banking and Financial Markets at Washington University, St. Louis, Missouri, October 29-30, 1982.
We describe a simple environment in which assets of varying qualities may be used for transactions and consumption. The quality of an asset is known to the seller but not the buyer. We show that this feature can generate a negative relationship between the transactions velocities of assets and their rates of return. We also discuss several versions of Gresham's Law which hold in this environment.
Current approaches to monetary theory and policy owe much to the "quantity theory of money." However, recent theoretical developments suggest that the manner in which money is introduced is more important, even for price level movements, than the quantity of money. Colonial American experience provides a laboratory for discriminating between these views. It is shown here that the nature of backing, rather than the quantity of money, determined its value. Large secular inflations were ended by changing the nature of backing despite the continuance of large note issues (and despite the absence of a metallic standard). Extremely large note issues and note withdrawals are shown not to have produced inflation (currency depreciation) or deflation (currency appreciation).
"Summary of Recommendations: . . . Repeal present control by the System over interest rates that member banks may pay on time deposits and present prohibition of interest payments by member banks on demand deposits." Milton Friedman (1960, p. 100) "I conclude that the over-all monetary effects of ceiling regulations are small and easy to neutralize by traditional monetary controls. The allocative and distributive effects are, however, unfortunate. The root of the policy was an exaggerated and largely unnecessary concern for the technical solvency of savings and loan associations." James Tobin (1970, p. 5) The regulation of deposit interest rates has received little support from economists. The same is true for the original rationale for such regulation: that bank competition for deposits generates inherent "instability" in the banking system. This paper develops an "adverse selection" model of banking in which this rationale is correct. Moreover, in this model instability in the banking system can arise despite the presence of a "lender of last resort," and despite the absence of any need for "deposit insurance." However, in the world described, the regulation of deposit interest rates is shown to be an appropriate response to "instability" in the banking system. Finally, it is argued that "adverse selection" models of deposit interest rate determination can confront a number of observed phenomena that are not readily explained in other contexts.
We study an overlapping generations model which contains a capital good that resembles actual gold. This capital good can he stored without physically depreciating and can, by using other resources, be converted back and forth between gold jewelry which yields utility directly and raw gold which does not.Under the assumption that the three utility-yielding objects—first and second period consumption and jewelry—are gross substitutes, stationary equilibria are shown to exist and are characterized; for some parameter values, there are inefficient equilibria, while for others there are efficient equilibria. Both types can be interpreted as commodity money equilibria.
Cover note : "An earlier version of this paper was presented at a seminar at MIT."
Our goal is to provide a theoretical framework in which both positive and normative aspects of international currency can be addressed in a systematic way. To this end, we use the framework of random matching games and develop a two country model of the world economy, in which two national fiat currencies compete and may be circulated as media of exchange. There are multiple equilibria, which differ in the areas of circulation of the two currencies. In one equilibrium, the two national currencies are circulated only locally. In another, one of the national currencies is circulated as an international currency. There is also an equilibrium in which both currencies are accepted internationally. We also find an equilibrium in which the two currencies are directly exchanged. The existence conditions of these equilibria are characterized, using the relative country size and the degree of economic integration as the key parameters. In order to generate sharper predictions in the presence of multiple equilibria, we discuss an evolutionary approach to equilibrium selection, which is used to explain the evolution of the international currency as the two economies become more integrated. Some welfare implications are also discussed. For example, a country can improve its national welfare by letting its own currency circulated internationally, provided the domestic circulation is controlled for. When the total supply is fixed, however, a resulting currency shortage may reduce the national welfare.
This paper argues that versions of Samuelson/Cass-Yaari overlapping-generations consumption-loans models ought to be taken seriously as models of fiat money. The case is made by summarizing and interpreting what these models have to say about fiat money and by arguing that these properties are robust in the sense that they can be expected to hold in any model of fiat money. Two of the properties establish the connection between, on the one hand, the existence of equilibria in which value is attached to a fixed stock of fiat money and, on the other hand, the optimality of such equilibria and the nonoptimality of nonfiat-money equilibria. Other properties describe aspects of the tenuousness of monetary equilibria in such models: The nonuniqueness of such equilibria in the sense that there always exists a nonfiat-money equilibrium and the dependence of the existence of the monetary equilibrium on the physical characteristics of other potential assets and on other institutional features like the tax-transfer scheme in effect. Rather than being defects of these models, it is argued that this tenuousness is helpful in interpreting various monetary systems and, in any case, is unavoidable; it will turn up in any good model of fiat money. Still other properties summarize what these models imply about the connection—or, better, lack of such— between fiat money and private borrowing and lending (financial intermediation) and what they imply about country-specific monies.
A model with private information is constructed that supports conventional arguments for a government monopoly in supplying circulating media of exchange. The model also yields predictions, including rate-of-return dominance of circulating media of exchange, that are consistent with observations from free banking regimes and fiat money regimes. In a laissez faire banking equilibrium, fiat money is not valued, and the resulting allocation is not Pareto optimal. However, if private agents are restricted from issuing circulating notes, there exists an equilibrium with valued fiat money that Pareto dominates the laissez faire equilibrium and is constrained Pareto optimal.
We use minute-by-minute daily transaction-level payments data to document the cross-sectional and time-series behavior of the estimated prices and quantities negotiated by commercial banks in the fed funds market. We study the frequency and volume of trade, the size distribution of loans, the distribution of bilateral fed funds rates, and the intraday dynamics of the reserve balances held by commercial banks. We find evidence of the importance of the liquidity provision achieved by commercial banks that act as de facto intermediaries of fed funds.
This paper examines two different clearing arrangements for bank liabilities. One was a profit-maximizing private entity, the Suffolk Banking System. It cleared notes for New England banks between 1827 and 1858. The other was a nonprofit collective, the clearinghouses organized in many cities beginning in 1853. The paper examines how well these arrangements prevented bank failures and acted as lenders of last resort. It finds the Suffolk system had fewer failures but acted less like a lender of last resort. It argues that these differences can be explained by the different incentives facing the Suffolk Bank and the members of clearinghouses.
Why do some sellers set nominal prices that apparently do not respond to changes in the aggregate price level? In many models, prices are sticky by assumption; here it is a result. We use search theory, with two consequences: prices are set in dollars, since money is the medium of exchange; and equilibrium implies a nondegenerate price distribution. When the money supply increases, some sellers may keep prices constant, earning less per unit but making it up on volume, so profit stays constant. The calibrated model matches price-change data well. But, in contrast with other sticky-price models, money is neutral.
Prior to 1861, several U.S. states established bank liability insurance schemes. One type was an insurance fund. Member banks paid into a state-run fund that paid bank creditors’ losses. A second scheme was a mutual guarantee system. Member banks were legally responsible for the liabilities of any insolvent bank. This paper’s hypothesis is that the moral hazard problem was controlled under a scheme to the degree that member banks had the power and incentive to control or modify others’ risk-taking behavior. Schemes that gave member banks both strong incentives and power were able to control the moral hazard problem better than schemes in which one or both features were weak. Empirical evidence on bank failures and losses on banks’ asset portfolios is consistent with this hypothesis.
The possibility of regime shifts in monetary policy can have important effects on rational agents’ expectation formation and equilibrium dynamics. In a DSGE model where the monetary policy rule switches between a dovish regime that accommodates inflation and a hawkish regime that stabilizes inflation, the expectation effect is asymmetric across regimes. Such an asymmetric effect makes it difficult, but still possible, to generate substantial reductions in the volatilities of inflation and output as the monetary policy switches from the dovish regime to the hawkish regime.
The behavior of interest rates under the U.S. National Banking System is puzzling because of the apparent presence of persistent and large unexploited arbitrage opportunities for note issuing banks. Previous attempts to explain interest rate behavior have relied on the cost or the inelasticity of note issue. These attempts are not entirely satisfactory. Here we propose a new rationale to solve the puzzle. Inelastic note issuance arises endogenously because the marginal cost of issuing notes is an increasing function of circulation. We build a spatial separation model where some fraction of agents must move each period. Banknotes can be carried between locations; deposits cannot. Taking the model to the data on national banks, we find it matches the movements in long-term interest rates well. It also predicts movements in deposit rates during panics. However, the model displays more inelasticity of notes issuance than is in the data.
We show that the desirability of fiscal constraints in monetary unions depends critically on the extent of commitment of the monetary authority. If the monetary authority can commit to its policies, fiscal constraints can only impose costs. If the monetary authority cannot commit, there is a free-rider problem in fiscal policy, and fiscal constraints may be desirable.
Until the mid-19th century, shortages of currency were sometimes serious problems. One common response was to prohibit the export of coins. We use a random matching model with indivisible money to explain a shortage and to judge the desirability of a prohibition on the export of coins. The model, although extreme in many regards, represents better than earlier models a demand for outside money and the problems that arise when that money is indivisible. It can also rationalize a prohibition on the export of coins.
A random matching model with money is used to study the nominal yield on small denomination, bearer, safe, discount securities issued by the government. There is always one steady state with matured securities circulating at par and, for some parameters, another with them circulating at a discount. In the former, a necessary and sufficient condition for a positive nominal yield on not-yet-matured securities is exogenous discriminatory treatment of them by the government. In the latter, the post-maturity discount on securities induces a deeper pre-maturity discount even without such discriminatory treatment.
In this chapter, we review the monetary and fiscal history of Argentina for the period 1960–2017, a time during which the country suffered several balance of payments crises, three periods of hyperinflation, two defaults on government debt, and three banking crises. All told, between 1969 and 1991, after several monetary reforms, thirteen zeros had been removed from its currency. We argue that all these events are the symptom of a recurrent problem: Argentina’s unsuccessful attempts to tame the fiscal deficit. An implication of our analysis is that the future economic evolution of Argentina depends greatly on its ability to develop institutions that guarantee that the government does not spend more than its genuine tax revenues over reasonable periods of time.
The optimal choice of a monetary policy instrument depends on how tight and transparent the available instruments are and on whether policymakers can commit to future policies. Tightness is always desirable; transparency is only if policymakers cannot commit. Interest rates, which can be made endogenously tight, have a natural advantage over money growth and exchange rates, which cannot. As prices, interest and exchange rates are more transparent than money growth. All else equal, the best instrument is interest rates and the next-best, exchange rates. These findings are consistent with the observed instrument choices of developed and less-developed economies.
I characterize time consistent equilibrium in an economy with price rigidity and an optimizing monetary authority operating under discretion. Firms have the option to increase their frequency of price change, at a cost, in response to higher inflation. Previous studies, which assume a constant degree of price rigidity across inflation regimes, find two time consistent equilibria—one with low inflation, the other with high inflation. In contrast, when price rigidity is endogenous, the high inflation equilibrium ceases to exist. Hence, time consistent equilibrium is unique. This result depends on two features of the analysis: (1) a plausible quantitative specification of the fixed cost of price change, and (2) the presence of an arbitrarily small cost of inflation that is independent of price rigidity.
This study examines the pricing of U.S. state banknotes before 1860 using discount data from New York, Philadelphia, Cincinnati, and Cleveland. The study determines whether these banknotes were priced consistent with their expected net redemption value as securities are. The evidence is mixed. Prices for a bank’s notes were higher when the bank was redeeming its notes for specie than when it was not, and banknote prices generally reflected the costs of note redemption. However, the relationship between prices and redemption costs was not tight, and there were cases in which the notes of distant banks went at par.
We construct a model where capital competes with fiat money as a medium of exchange, and we establish conditions on fundamentals under which fiat money can be both valued and socially beneficial. When the socially efficient stock of capital is too low to provide the liquidity agents need, they overaccumulate productive assets to use as media of exchange. When this is the case, there exists a monetary equilibrium that dominates the nonmonetary one in terms of welfare. Under the Friedman Rule, fiat money provides just enough liquidity so that agents choose to accumulate the same capital stock a social planner would.
We analyze the setting of monetary and nonmonetary policies in monetary unions. We show that in these unions a time inconsistency problem in monetary policy leads to a novel type of free-rider problem in the setting of nonmonetary policies, such as labor market policy, fiscal policy, and bank regulation. The free-rider problem leads the union’s members to pursue lax nonmonetary policies that induce the monetary authority to generate high inflation. The free-rider problem can be mitigated by imposing constraints on the nonmonetary policies, like unionwide rules on labor market policy, debt constraints on members’ fiscal policy, and unionwide regulation of banks. When there is no time inconsistency problem, there is no free-rider problem, and constraints on nonmonetary policies are unnecessary and possibly harmful.
In this paper, I provide a possible explanation of why nominally risk-free bonds are essential in monetary economies. I argue that the role of nominal bonds is to serve as record-keeping devices in intertemporal exchanges of money. I show that bonds can only serve this role if they are illiquid (costly to exchange for goods). Finally, I show that in economies in which nominal bonds are essential, welfare and nominal interest rates are both positively associated with the supply of illiquid bonds (if that supply is small).
We develop a model of commodity money and use it to analyze the following two questions motivated by issues in monetary history: What are the conditions under which Gresham’s Law holds? And, what are the mechanics of a debasement (lowering the metallic content of coins)? The model contains light and heavy coins, imperfect information, and prices determined via bilateral bargaining. There are equilibria with neither, both, or only one type of coin in circulation. When both circulate, coins may trade by weight or by tale. We discuss the extent to which Gresham’s Law holds in the various cases. Following a debasement, the quantity of reminting depends on the incentives offered by the sovereign. Equilibria exist with positive seigniorage and a mixture of old and new coins in circulation.
According to previous studies, the demand-liability feature of national bank notes did not present a problem for note-issuing banks because the nonbank public treated notes and other currency as perfect substitutes. However, that view, when combined with nonbindingness of the collateral restriction against note issue, itself an implication of the fact that some eligible collateral was not used for that purpose, implies that the safe short-term interest rate is pegged at the tax rate on note circulation. Since evidence on short-term interest rates is inconsistent with such a peg, that view must be rejected.
Brazil has had a long period of high inflation. It peaked around 100 percent per year in 1964, decreased until the first oil shock (1973), but accelerated again afterward, reaching levels above 100 percent on average between 1980 and 1994. This last period coincided with severe balance of payments problems and economic stagnation that followed the external debt crisis in the early 1980s. We show that the high-inflation period (1960-1994) was characterized by a combination of fiscal deficits, passive monetary policy, and constraints on debt financing. The transition to the low-inflation period (1995-2016) was characterized by improvements in all of these features, but it did not lead to significant improvements in economic growth. In addition, we document a strong positive correlation between inflation rates and seigniorage revenues, although inflation rates are relatively high for modest levels of seigniorage revenues. Finally, we discuss the role of the weak institutional framework surrounding the fiscal and monetary authorities and the role of monetary passiveness and inflation indexation in accounting for the unique features of inflation dynamics in Brazil.