Trust Shocks, Financial Crises, and Money

A precondition for a well-functioning monetary system is trust. This paper develops a neoclassical general equilibrium model in which public and private money coexist and the impact of trust shocks on the macroeconomy is examined. In this paper, trust is modelled as limited commitment between borrowers and lenders. A borrower who issues private money can credibly commit to repay at most a fraction of his or her future output. The paper shows that a lack of trust can engineer a financial crisis, with substantial effects on both the real and monetary variables. In the model, an unexpected drop in the trust parameter causes young workers to divert less of their savings into investment goods and more of their savings into consumption goods. A fall in capital investment in turn leads to a decline in real output. I also show that trust shocks can have detrimental effects on both workers and entrepreneurs. In addition, the model shows that, to clear the money market, an increase in the real demand for government money causes the price level to fall, inducing transitory deflation. This is in line with the low inflation episodes during and following the Great Recession. The decline in capital investment and the price level also implies that the amount of deposits has to shrink in a financial crisis. Finally, once trust shocks hit the economy, the money multiplier drops. This is due to the decrease in capital investment and the increase in the real demand for government money.