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Banking, Inside Money and Outside Money

  • Sun, Hongfei

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: first, 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 dominates outside money because the former makes it less costly to induce truthful revelation and achieve more efficient risk sharing.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 4504.

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Date of creation: Aug 2007
Date of revision:
Handle: RePEc:pra:mprapa:4504
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  1. David Andolfatto & Ed Nosal, 2001. "A simple model of money and banking," Economic Review, Federal Reserve Bank of Cleveland, issue Q III, pages 20-28.
  2. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
  3. S. Rao Aiyagari & Stephen D. Williamson, 1998. "Money and dynamic credit arrangements with private information," Working Paper 9807, Federal Reserve Bank of Cleveland.
  4. Cavalcanti, Ricardo de O & Wallace, Neil, 1999. "Inside and Outside Money as Alternative Media of Exchange," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 443-57, August.
  5. Sun, Hongfei, 2007. "Aggregate uncertainty, money and banking," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 1929-1948, October.
  6. David Andolfatto & Ed Nosal, 2003. "A Theory of Money and Banking," Macroeconomics 0310003, EconWPA.
  7. Stephen Williamson, 2004. "Limited participation, private money, and credit in a spatial model of money," Economic Theory, Springer, vol. 24(4), pages 857-875, November.
  8. Ping He & Lixin Huang & Randall Wright, 2005. "Money And Banking In Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 637-670, 05.
  9. 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.
  10. Miquel Faig, 2006. "Divisible Money In An Economy With Villages," Working Papers tecipa-216, University of Toronto, Department of Economics.
  11. Shouyong Shi, 1996. "Credit and Money in a Search Model with Divisible Commodities," Review of Economic Studies, Oxford University Press, vol. 63(4), pages 627-652.
  12. Andrew Atkeson & Robert E. Lucas, 1992. "On Efficient Distribution With Private Information," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 427-453.
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