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Banking, Inside Money and Outside Money

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  • Sun, Hongfei

Abstract

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.

Suggested Citation

  • Sun, Hongfei, 2007. "Banking, Inside Money and Outside Money," MPRA Paper 4504, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:4504
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    References listed on IDEAS

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    1. Miquel Faig, 2004. "Divisible Money in an Economy with Villages," Levine's Bibliography 122247000000000159, UCLA Department of Economics.
    2. David Andolfatto & Ed Nosal, 2003. "A theory of money and banking," Working Papers (Old Series) 0310, Federal Reserve Bank of Cleveland.
    3. Ricardo de O. Cavalcanti & Neil Wallace, 1999. "Inside and outside money as alternative media of exchange," Proceedings, Federal Reserve Bank of Cleveland, pages 443-468.
    4. Shouyong Shi, 1996. "Credit and Money in a Search Model with Divisible Commodities," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 63(4), pages 627-652.
    5. Andrew Atkeson & Robert E. Lucas, 1992. "On Efficient Distribution With Private Information," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 59(3), pages 427-453.
    6. Sun, Hongfei, 2007. "Aggregate uncertainty, money and banking," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 1929-1948, October.
    7. 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.
    8. Aiyagari, S. Rao & Williamson, Stephen D., 2000. "Money and Dynamic Credit Arrangements with Private Information," Journal of Economic Theory, Elsevier, vol. 91(2), pages 248-279, April.
    9. 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.
    10. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 887-916, June.
    11. Stephen D. Williamson, 2006. "Limited participation, private money, and credit in a spatial model of money," Studies in Economic Theory, in: Charalambos D. Aliprantis & Nicholas C. Yannelis & Gabriele Camera (ed.), Recent Developments on Money and Finance, pages 255-273, Springer.
    12. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
    13. 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, May.
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    Cited by:

    1. Mei Dong, 2009. "Money and Costly Credit," 2009 Meeting Papers 404, Society for Economic Dynamics.
    2. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 887-916, June.
    3. Hongfei Sun & Stella Huangfu, 2011. "Private money and bank runs," Canadian Journal of Economics/Revue canadienne d'économique, John Wiley & Sons, vol. 44(3), pages 859-879, August.
    4. Allen Head & Junfeng Qiu, 2007. "Elastic Money, Inflation, And Interest Rate Policy," Working Paper 1152, Economics Department, Queen's University.

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    More about this item

    Keywords

    banking; inside money; outside money;
    All these keywords.

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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