Research Database

Many claims have been made about the potential benefits and the potential costs of adopting a system of universal banking in the United States. We evaluate these claims using a model where there is a moral hazard problem between banks and "borrowers," a moral hazard problem between banks and a deposit insurer, and a costly state verification problem. Under conditions we describe, allowing banks to take equity positions in firms strengthens their ability to extract surplus, and exacerbates problems of moral hazard. The incentives of universal banks to take equity positions will often be strongest when these problems are most severe.

Using an existing random matching model of money, I show that a once-for-all change in the quantity of money has short-run effects that are predominantly real and long-run effects that are in the direction of being predominantly nominal provided (i) the quantity of money is random and (ii) people learn about what happened to it only with a lag. The change in the quantity of money comes about through a random process of discovery that does not permit anyone to deduce the aggregate amount discovered when the change actually occurs.

In 1985–86 the authors were members of a team that constructed a static applied general equilibrium model that was used to analyze the impact on the Spanish economy of the 1986 fiscal reform, which accompanied Spain’s entry into the European Community. This paper compares the results obtained to recently published data for 1985–87; we find that the model performed well in predicting the changes in relative prices and resource allocation that actually occurred, particularly if we incorporate exogenous shocks that affected the Spanish economy in 1986. We also analyze the sensitivity of the results to alternative specifications of the labor market and macroeconomic closure rules; we find that the central results are robust.

This paper demonstrates a connection between failure of Walras’ Law and nonoptimal equilibria in a quite general overlapping generations model. Consider the following implication of Walras’ Law in finite economies. Suppose that all prices are positive and that all agents are on their budget lines. Then, no matter how the set of goods is partitioned, there cannot be an excess supply (in value terms) for some other set in the partition with excess demand (in value terms) for some other set in the partition. We use the Cass (1972), Benveniste (1976, 1986), Balasko and Shell (1980), and Okuno and Zilcha (1980) price characterization of optimality of equilibria in pure exchange overlapping generations models to show the following link between the above implication of Walras’ Law and optimality of a competitive equilibrium. A competitive equilibrium is nonoptimal if and only if the above implication of Walras’ Law fails in its neighborhood.

We consider an environment in which risk-neutral firms must obtain external finance. They have access to two kinds of linear, stochastic investment opportunities. For one, return realizations are costlessly observed by all agents. For the other, return realizations are costlessly observed only by the investing firm; however, they can be (privately) observed by outsiders who bear a fixed verification cost. Thus, the second investment opportunity is subject to a standard costly state verification (CSV) problem of the type considered by Townsend (1979), Gale and Hellwig (1985), or Williamson (1986, 1987).

We examine the optimal allocations of investment between the two kinds of projects, as well as the optimal contract used to finance it. We show that the optimal contractual outcome can be supported by having firms issue appropriate (and determinate) quantities of debt and equity securities to outside investors.

The optimal debt-equity ratio necessarily depends (in part) on the firm’s asset structure. Investments in projects subject to CSV problems are associated (in a sense to be made precise) with the use of debt—as might be expected from the existing CSV literature. Investments in projects with publicly observable returns are associated with the use of external equity.

We examine in detail the relationship between the optimal asset and liability structure of the firm. We also describe conditions under which an increase in the cost of state verification shifts the composition of investment towards projects with observable returns, and reduces the optimal debt-equity ratio. Interestingly, the optimal debt-equity ratio is also shown to depend on factors that are irrelevant to asset allocations.

Finally, a large part of the interest in CSV environments has been due to the fact that they may result in equilibrium credit rationing. Our analysis has strong implications for the possibility of equilibrium credit rationing in more general CSV models.