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Imperfect monitoring and the discounting of inside money

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  • David C. Mills

Abstract

One of the fundamental questions concerning inside money is whether its issuers should be regulated and how. This paper evaluates the efficiency of one prevalent regulatory recommendation -- a requirement that private issuers redeem inside money on demand at par -- in a random-matching model of money where the issuers of inside money are only imperfectly monitored. I find that for sufficiently imperfect monitoring, a par redemption requirement leads to lower social welfare than if private money were redeemed at a discount. A central message of the paper is that if inside money and outside money are not perfect substitutes for one another, as is the case if there is sufficiently imperfect monitoring, a par redemption requirement may not be socially optimal because such a requirement effectively binds them to circulate as if they are. Such an outcome is a version of Gresham's law that bad money drives out good money.

Suggested Citation

  • David C. Mills, 2007. "Imperfect monitoring and the discounting of inside money," Finance and Economics Discussion Series 2007-58, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2007-58
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    Cited by:

    1. Chao Gu & Fabrizio Mattesini & Randall Wright, 2013. "Banking: A New Monetarist Approach," Review of Economic Studies, Oxford University Press, vol. 80(2), pages 636-662.
    2. Randall Wright & Cyril Monnet & Fabrizio Mattesini, 2009. "Banking: a mechanism design approach," 2009 Meeting Papers 635, Society for Economic Dynamics.
    3. Wallace, Neil, 2014. "An Attractive Monetary Model with Surprising Implications for Optima: Two Examples," Quarterly Review, Federal Reserve Bank of Minneapolis, issue March, pages 1-16.

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    Keywords

    Money ; Econometric models;

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