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Banking, Inside Money and Outside Money

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  • Sun, Hongfei

Abstract

This paper presents an integrated theory of money and banking. I address the following question: when both individuals and banks have private information, what is the optimal way to settle debts? I develop a dynamic model with micro- founded roles for banks and a medium of exchange. I establish two main results: rst, markets can improve upon the optimal dynamic contract at the presence of private information. Market prices fully reveal the aggregate states and help solve the incentive problem of the bank. Secondly, it is optimal for the bank to require loans be settled with short-term inside money, i.e., bank money that expires immediately after the settlement of debts. Short-term inside money makes it less costly to induce truthful revelation and achieve more efficient risk sharing.

Suggested Citation

  • Sun, Hongfei, 2007. "Banking, Inside Money and Outside Money," Queen's Economics Department Working Papers 273622, Queen's University - Department of Economics.
    • Handle: RePEc:ags:quedwp:273622
    DOI: 10.22004/ag.econ.273622
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    References listed on IDEAS

    as
    1. Azariadis, Costas & Bullard, James & Smith, Bruce D., 2001. "Private and Public Circulating Liabilities," Journal of Economic Theory, Elsevier, vol. 99(1-2), pages 59-116, July.
    2. Ricardo de O. Cavalcanti & Neil Wallace, 1999. "Inside and outside money as alternative media of exchange," Proceedings, Federal Reserve Bank of Cleveland, pages 443-468.
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    4. Bullard, James & Smith, Bruce D., 2003. "The value of inside and outside money," Journal of Monetary Economics, Elsevier, vol. 50(2), pages 389-417, March.
    5. Aiyagari, S. Rao & Williamson, Stephen D., 2000. "Money and Dynamic Credit Arrangements with Private Information," Journal of Economic Theory, Elsevier, vol. 91(2), pages 248-279, April.
    6. Stephen D. Williamson, 2006. "Limited participation, private money, and credit in a spatial model of money," Studies in Economic Theory, in: Charalambos D. Aliprantis & Nicholas C. Yannelis & Gabriele Camera (ed.), Recent Developments on Money and Finance, pages 255-273, Springer.
    7. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
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    Full references (including those not matched with items on IDEAS)

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