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Incomplete and the Endogeneity of Central Banking

  • Gary Gorton

In a model with incomplete markets, and agents privately producing a circulating media of exchange to coordinate trade, it is shown that closing another market can be Pareto-improving. Producing private money is costly because contracts with the money issuers must be enforced, creating agency costs. By closing the market for trading the circulating media, agents endogenously create an information asymmetry which can result in banking panics. The information asymmetry is desirable, however, because it creates externalities which force banks to cooperate for mutual regulation and insurance for their monies, thus reducing agency costs. The self-enforcing cooperative coalition of banks replaces the market in enforcing the private money contracts. Agents relying on this unobservable enforcement are said to have "confidence" in the banking system.

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Paper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 16-87.

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Handle: RePEc:fth:pennfi:16-87
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