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A Theory of Money and Banking

Author

Listed:
  • David Andolfatto

    (Simon Fraser University)

  • Ed Nosal

    (Federal Reserve Bank of Cleveland)

Abstract

We construct a simple environment that combines a limited communication friction and a limited information friction in order to generate a role for money and intermediation. We ask whether there is any reason to expect the emergence of a banking sector (i.e., institutions that combine the business of money creation with the business of intermediation). In our model the unique equilibrium is characterized, in part, by the existence of an agent that: (1) creates money (a debt instrument that circulates as a means of payment); (2) lends it out (swapping it for less liquid forms of debt); (3) is responsible for monitoring those agents in control of the capital backing the illiquid debt; and (4) collects on money loans as they come due. Furthermore, the bank money in our model is a debt instrument that embeds within it important stipulations that are found in actual private money instruments. Thus, our model goes some way in addressing the questions of why private money takes the form that it does, as well as why private money is typically supplied by banks.

Suggested Citation

  • David Andolfatto & Ed Nosal, 2003. "A Theory of Money and Banking," Macroeconomics 0310003, EconWPA.
  • Handle: RePEc:wpa:wuwpma:0310003
    Note: Type of Document - Tex; prepared on IBM PC; to print on Lexmark Optra E310; pages: 30; figures: included
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    References listed on IDEAS

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    1. 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.
    2. Bullard, James & Smith, Bruce D., 2003. "Intermediaries and payments instruments," Journal of Economic Theory, Elsevier, vol. 109(2), pages 172-197, April.
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    4. Krasa, Stefan & Villamil, Anne P, 1992. "A Theory of Optimal Bank Size," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 725-749, October.
    5. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    6. 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.
    7. Maskin, Eric & Tirole, Jean, 1992. "The Principal-Agent Relationship with an Informed Principal, II: Common Values," Econometrica, Econometric Society, vol. 60(1), pages 1-42, January.
    8. Douglas W. Diamond, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Oxford University Press, vol. 51(3), pages 393-414.
    9. Williamson, Stephen D., 1986. "Costly monitoring, financial intermediation, and equilibrium credit rationing," Journal of Monetary Economics, Elsevier, vol. 18(2), pages 159-179, September.
    10. David E. Laidler, 1988. "Taking Money Seriously," Canadian Journal of Economics, Canadian Economics Association, vol. 21(4), pages 687-713, November.
    11. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, vol. 111(1), pages 103-123, February.
    12. Neil Wallace, 1988. "Another attempt to explain an illiquid banking system: the Diamond and Dybvig model with sequential service taken seriously," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 3-16.
    13. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
    14. 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.
    15. Ricardo O. Cavalcanti, 2004. "A monetary mechanism for sharing capital: Diamond and Dybvig meet Kiyotaki and Wright," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 24(4), pages 769-788, November.
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    17. Douglas Gale & Martin Hellwig, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Oxford University Press, vol. 52(4), pages 647-663.
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    Cited by:

    1. Wen, Yi, 2015. "Money, liquidity and welfare," European Economic Review, Elsevier, vol. 76(C), pages 1-24.
    2. Sun, Hongfei, 2007. "Aggregate uncertainty, money and banking," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 1929-1948, October.
    3. Yi Wen, 2012. "Liquidity and welfare," Working Papers 2012-037, Federal Reserve Bank of St. Louis.
    4. Chiu, Jonathan & Meh, Césaire A., 2011. "Financial Intermediation, Liquidity, And Inflation," Macroeconomic Dynamics, Cambridge University Press, vol. 15(S1), pages 83-118, April.
    5. He, Ping & Huang, Lixin & Wright, Randall, 2008. "Money, banking, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 55(6), pages 1013-1024, September.
    6. Diarmid Weir, 2013. "Fiat Money, Individual Rationality and Production," Metroeconomica, Wiley Blackwell, vol. 64(4), pages 573-590, November.
    7. COCIUG, Victoria & TIMOFEI, Olga, 2014. "Monetary Policy Force Effect By Means Of Banks Money Creation," Studii Financiare (Financial Studies), Centre of Financial and Monetary Research "Victor Slavescu", vol. 18(2), pages 18-28.
    8. Kahn, Charles M. & Roberds, William, 2009. "Why pay? An introduction to payments economics," Journal of Financial Intermediation, Elsevier, vol. 18(1), pages 1-23, January.
    9. Sun, Hongfei, 2007. "Banking, Inside Money and Outside Money," MPRA Paper 4504, University Library of Munich, Germany.
    10. Geoffrey Dunbar, 2005. "International Lending, Capital Controls and Wealth Inequality," 2005 Meeting Papers 492, Society for Economic Dynamics.

    More about this item

    Keywords

    Money; Banking;

    JEL classification:

    • E - Macroeconomics and Monetary Economics

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