Imperfect Contract Enforcement and Nominal Liabilities

This paper introduces the court's inability to discern different qualities of goods of the same kind into an overlapping generations model. This friction makes fiat money circulate not only as a means of payments for goods, but also as a means of liability repayments in an equilibrium. This result holds with or without dynamic inefficiency. In this equilibrium, a shortage of real money balances for liability repayments can cause underinvestment by borrowers, even if the money supply follows a Friedman rule. This problem can be resolved by an elastic money supply through an intraday discount window at a zero discount fee. In this case, supplying no fiat money overnight maximizes aggregate consumption in a monetary steady state in a dynamically efficient economy. This policy, however, can also lead to a self-fulfilling crunch of discount window lending if commercial banks intermediate the lending from the central bank with a collateral constraint, and if the discount window market is segregated. This equilibrium can be eliminated if the central bank is the monopolistic public issuer of fiat money that also acts as the lender of last resort.