On the inherent instability of private money
We show the existence of an inherent instability associated with a purely private monetary system due to the role of endogenous debt limits in the creation of private money. Because the bankers’ ability to issue liabilities that circulate as a medium of exchange depends on beliefs about future credit conditions, there can be multiple equilibria. Some of these equilibria have undesirable properties: Self-fulfilling collapses of the banking system and persistent fluctuations in the aggregate supply of bank liabilities are possible. In response to this inherent instability of private money, we formulate a government intervention that guarantees that the economy remains arbitrarily close to the constrained efficient allocation. In particular, we define an operational procedure for a central bank capable of ensuring the stability of the monetary system.
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