Counterfeiting as Private Money in Mechanism Design
We find that in order to have circulating counterfeit notes as part of the optimal mechanism, there must be heterogeneity of opportunities to create and circulate counterfeit among agents. When such heterogeneity exists, we find that counterfeiting creates distortions at both the intensive and extensive margins. That is, output will tend to "low" and the supply of money will tend to be "high," compared to an environment where counterfeiting is not possible. When there is no heterogeneity in opportunities to create and circulate counterfeit notes, then, like in Nosal and Wallace (2005), although the threat of counterfeiting has negative implications for welfare, the optimal mechanism will not allow counterfeit notes to circulate.
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