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FEDERAL RESERVE BANK OF CLEVELAND pd papers NUMBER 23 By Ed Nosal and Randall Wright POLICY DISCUSSION PAPER The 2007 Summer Workshop on Money, Banking and Payments: An Overview DECEMBER 2007 POLICY DISCUSSION PAPERS FEDERAL RESERVE BANK OF CLEVELAND The 2007 Summer Workshop on Money, Banking and Payments: An Overview By Ed Nosal and Randall Wright Ed Nosal is a senior economic advisor at the Federal Reserve Bank of Cleveland and Randall Wright is the James Kim Professor of Economics at the University of Pennsylvania. The 2007 Summer Workshop on Money, Banking, Payments and Finance met at the Federal Reserve Bank of Cleveland this summer, as we have over the past several years. The following document summarizes and ties together the contributions presented at the workshop this year. Materials may be reprinted, provided that the source is credited. Please send copies of reprinted materials to the editor. 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ISSN 1528-4344 FEDERAL RESERVE BANK OF CLEVELAND Introduction The 35 papers presented at this year’s meeting can be broadly grouped into ﬁve topics: foundations, which involves work on relatively deep issues in monetary theory; central banking and monetary policy, which concerns applied issues more or less directly related to policy making; ﬁscal and monetary policy, which involves the interconnections between these two types of policy; ﬁnancial intermediation and banking, which is concerned with intermediation in general and especially the roles of banks; and money and bonds, which considers the relation between two particular assets and asks how they interact. Foundations Quasilinear preferences are very convenient in several ﬁelds of economics, but especially in modern monetary economics. In “Stationarity and Degeneracy in a Commodity Money Model,” Ricardo Cavalcanti and Daniela Puzzello take a step toward a better understanding of the role of quasilinearity by examining the implications of these preferences for optimal allocations in a theoretic analysis of an economy with commodity money. In the Stationarity and Degeneracy in a Commodity Money Model Ricardo Cavalcanti and Daniela Puzzello ﬁrst stage, agents are randomly matched, with exogenous probabilities they are either producers or consumers in that match, and they then make decisions on whether or not to trade. In the second stage, agents part and decide to produce and consume a different (storable) good that can act as commodity money, although the storage technology is subject to shocks. Cavalcanti and Puzzello take an implementability approach:They ﬁnd that the planner’s problem can be reduced to a sequence of very simple (essentially static) problems.They also show that the distribution of money may or may not be degenerate, and that allowing buyers to make take-it-or-leave-it others is optimal. Quasilinearity is the key to these results.The approach can be extended to more complex environments, and hence the tools they develop may prove quite generally applicable. In “Competing Auctions in a Monetary Economy,” Richard Dutu, Benoit Julien, and Ian King consider an economy where goods are allocated by ascending bid auctions, and sellers compete for buyers through the reserve price of their auction. The environ- Competing Auctions in a Monetary Economy Richard Dutu, Benoit Julien, and Ian King ment has several novel and interesting features. First, sellers decide on the quantity of the good to be auctioned. There is a trade-off for sellers between production costs and the expected number of buyers they attract. Also, sellers compete in both the posted quantity and the reserve price. Buyers choose how much money to bring to the market, which implies a trade-off between the cost of holding money and the expected gain from winning an auction. The model predicts that inﬂation cannot be too low or too high for a monetary equilibrium to exist and that increasing inﬂation decreases the equilibrium-posted quantity and the number of buyers. Efﬁciency is attained for the lowest 1 POLICY DISCUSSION PAPERS NUMBER 23, DECEMBER 2007 possible inﬂation rate that is compatible with the existence of monetary equilibrium. This kind of work greatly extends our understanding of monetary economies because it shows how alternative mechanisms like auctions (and unlike bargaining or price posting, for example, as in most previous work) can be incorporated. In “Counterfeiting as Private Money in Mechanism Design,” Ricardo Cavalcanti and Ed Nosal describe counterfeiting activity as the issuance of private money that is difﬁcult to monitor.Their approach, which extends the basic random- matching model of money, allows a tractable welfare analysis of currency competition. They show that it is not ef- Counterfeiting as Private Money in Mechanism Design Ricardo Cavalcanti and Ed Nosal ﬁcient to eliminate counterfeiting completely, and argue that their model is consistent with the idea of imperfect monitoring. This kind of analysis aids our understanding of how money may work when it is possible to cheat the system by counterfeiting. In “On the Uniqueness of Steady State Monetary Equilibrium in the Alternating Mar- generalizes the one in Lagos and Wright, which is a very tractable framework for mon- On the Uniqueness of Steady State Monetary Equilibrium in the Alternating Market Model of Money etary theory and policy analysis, based on quasilinear preferences.Then he clears up the Randall Wright ket Model of Money,” Randall Wright does the following. First, he presents a model that following loose end in previous analyses of these kinds of models: previously, only under rather severe conditions on bargaining or nonstandard assumptions on preferences and technology has it been known that a unique monetary steady state exists. Wright proves uniqueness without any conditions on bargaining or nonstandard assumptions on primitives.This is very useful, since many people are currently using the framework, and they have been previously forced to present only an incomplete characterization of steady states. Now one can say in these papers that the equilibrium being analyzed is unique. As a corollary, it is shown that the model implies monotone comparative statics for a wide class of parameter changes. In “A Hotelling Model with Money,” Dean Corbae and Borghan Narajabad study how tastes and technology simultaneously determine product variety and the choice of exchange mechanism (e.g., money versus barter).They study the interaction between the A Hotelling Model with Money Dean Corbae and Borghan Narajabad exchange mechanism and product variety.The novel part of the analysis follows from the observation that the addition of more barter shops substitute for one another while the addition of more money shops actually complement one another.They solve for optimal incentive feasible allocations and implement the solution as a trading post economy. In “One Money or Two Monies?” Mei Dong and Janet Hua Jiang show that having two One Money or Two Monies? monies (instead of just one) improves welfare in an environment with private information. They use a version of the Lagos-Wright model, where activities in each period occur over two sequential stages characterized by ﬁrst centralized and then decentralized trade. At the beginning of each period, agents possess two layers of private information, which pertains to probability distributions over their taste and technology parameters. Agents sort themselves by choosing different monies before the realization of the shocks.The existence of a second money improves welfare because the sorting relaxes 2 Mei Dong and Janet Hua Jiang FEDERAL RESERVE BANK OF CLEVELAND incentive-compatibility constraints associated with the private information about the taste parameter.This kind of theory greatly enhances our understanding of the kinds of institutions that work well under various types of frictions, including private information. In “Markets and Relationships in a Learning Economy,” Luis Araujo and Raoul Minetti pursue a new explanation for the determination of market structure. Generally speaking, Markets and Relationships in a Learning Economy one can think of two basic structures under which exchange occurs. In one—transac- Luis Araujo and Raoul Minetti tions-based—agents engage in spot trades, and frequently break matches with current partners to match with new ones. In another—relationship-based—agents repeatedly exchange within a match. In many markets, some exchanges occur in each mode. The empirical structure of market exchange exhibits sharp cross-country variation, and it is sometimes argued that variations in the structure of markets can help explain crosscountry differences in economic performance. Araujo and Minetti study the structure of the credit market that arises when agents must learn about aggregate productivity from market exchange. This kind of model allows one to relate credit market structure to macroeconomic fundamentals, such as the persistence and volatility of aggregate productivity, and hence may ultimately be useful for empirical or policy analysis. Central Banking and Monetary Policy Economists working in the area of monetary theory and policy have had two goals.They have tried to formulate models of monetary policy in which money (currency) has a wellunderstood role. And they have hoped to ﬁnd that optimal policy is guided by simple principles that are not too dependent on details of the model. In “Optimal Central-Bank Intervention: An Example,” Alexei Deviatov and Neil Wallace study optimal policy in an example that satisﬁes the ﬁrst goal but not the second. The ingredients of the example are: (i) heterogeneity in the degree to which different people are monitored; (ii) idiosyncratic shocks that give rise to heterogeneity in earning Optimal Central-Bank Intervention: An Example Alexei Deviatov and Neil Wallace and spending realizations; and (iii) central-bank intervention in a credit market in which the participants are those who are heavily monitored. Ingredient (i)—the existence of people who are hardly monitored—gives rise to a role for money: those who are hardly monitored cannot get credit. The combination of (i) and (ii) produces the following problem: the hardly monitored are at times liquidity constrained, and at other times, they have so much liquidity that they have little incentive to earn more. Finally, (iii) implies that the connection between central-bank intervention and the liquidity problem is indirect because those who are hardly monitored are not participants in the market in claims.That accounts for why the example does not satisfy the second goal.Although (i)-(iii) are not controversial, there is no other analysis of optimal policy in the literature that rests on those ingredients.There are several reasons. First, only recently have models 3 POLICY DISCUSSION PAPERS NUMBER 23, DECEMBER 2007 been formulated that augment (ii) with ingredients (i) and (iii). Second, because most models of central-bank intervention do not satisfy the ﬁrst goal, the idea that centralbank activity should be geared to solving the economic problem implied by (i) and (ii) is not widely accepted. But perhaps it ought to be. Central banks have a monopoly on money. If money has a role because some people are imperfectly monitored, then it is not far-fetched to suggest that management of that monopoly should be directed at something closely related to what makes money important. Moreover, recall that central banks in several countries emerged as legally mandated monopoly issuers of banknotes from systems in which there were originally many private banks issuing notes. Given such a monopoly, there is a role for two arrangements that partially substitute for private note issue: trade in claims among the would-be issuers of private banknotes (something like a credit market); and central-bank participation in such trade.The model in this paper includes versions of those arrangements. In “Adverse Selection and the Role of Monetary Policy,” Daniel Sanches and Steve Williamson discuss the following issue. When agents engage in monetary exchange, they may be imperfectly informed about the future trading opportunities of their trading partners. This creates an inefﬁciency relative to full information, and policy can poten- Adverse Selection and the Role of Monetary Policy Daniel Sanches and Steve Williamson tially correct this distortion. Sanches and Williamson, following Lagos and Wright, assume agents alternate between centralized and decentralized exchange. However, centralized markets are segmented and, as a result, the value of money will be different in each location. In decentralized exchange, agents are bilaterally matched and contracts are distorted due to private information.When the central bank is able to intervene in both locations, the Friedman rule can correct all frictions. When ﬁnancial trade is allowed across locations in the centralized market, prices are 4 equalized and the Friedman rule can again work. However, when the central bank is constrained to intervene in only one location, the Friedman rule is in general not feasible and it is not generally possible to eliminate the frictions entirely. In “Public Information and Monetary Policy,” Marie Hoerova, Cyril Monnet, and Ted Temzelides study monetary policy in a model where uncertainty can lead to a discrepancy between agents’ beliefs and true fundamentals. Following the work of Morris and Shin, the key feature is that investment decisions are subject to a “beauty contest” element: additional consumption is more beneﬁcial if other agents also consume more of the good. The model departs from Morris and Shin’s static approach by introducing an inﬁnite time horizon and making money essential. The spatial separation of agents prevents prices from being fully revealing, and allows the authors to study the interplay between monetary and informational frictions.A central assumption in the model is that monetary policy is the only way for the central bank to credibly transmit its information about fundamentals. The model offers an information-based argument for the idea that higher nominal rate hikes occur less frequently than lower ones. 4 Public Information and Monetary Policy Marie Hoerova, Cyril Monnet, and Ted Temzelides FEDERAL RESERVE BANK OF CLEVELAND In “Central Bank Design with Heterogeneous Agents,” Aleksander Berentsen and Carlo Strub study alternative decision-making models for the determination of monetary policy. They consider a model where agents have either a high or a low utility from consumption. The main consequence of this heterogeneity is that there is a two-point Central Bank Design with Heterogeneous Agents Aleksander Berentsen and Carlo Strub distribution of money holdings and, therefore, monetary policy has redistributive effects. Simple majority voting, supermajority voting, a policy board, and other mechanisms for determining policy are compared. The social planner’s desired policy is the Friedman rule. This can be attained if, under simple majority voting, the agents with low-inﬂation preferences have the majority. Under bargaining, the ﬁrst-best can only be attained when transfers are feasible. Under all other central bank designs the equilibrium outcome does not attain the ﬁrst-best. One interesting result is that when there are two separate economies, one populated by agents with low preferences for consumption and the other by agents with high preferences for consumption, each prefers the Friedman rule. If these two economies form a monetary union, however, then a deviation from the Friedman rule can occur. In “Uncertainty, Inﬂation and Welfare,” Jonathan Chiu and Miguel Molico study the costs and the redistributive effects of inﬂation in the presence of partially-insurable idiosyncratic risk. Building on Lagos and Wright, the model emphasizes two empirically plausible features. First, economic agents face idiosyncratic uncertainty regarding pro- Uncertainty, Inﬂation and Welfare Jonathan Chiu and Miguel Molico ductivity, preferences, and trading opportunities. Second, agents are unable to fully insure against such risk.These features introduce a technical challenge, since to solve the model, one must keep track of the distribution of money holdings (note they generalize the standard model by relaxing the assumption of quasilinear preferences). The model is calibrated and solved computationally. They ﬁnd that the long-run welfare costs of low and moderate inﬂations are on average 40% smaller than predicted by a completemarket model.This style of work greatly enhances 5 the class of models we can study by showing how to solve much more complicated environments that we usually analyze on the computer. In “Elastic Money, Inﬂation, and Interest Rate Policy,”Allen Head and Junfeng Qiu study optimal monetary policy in an environment where aggregate shocks affect individual Elastic Money, Inﬂation, and Interest Rate Policy agents asymmetrically, and exchange may be conducted using either bank deposits (in- Allen Head and Junfeng Qiu side money) or ﬁat currency (outside money). By controlling interest rates, the monetary authority can affect the price level and consumption, thus providing insurance against unfavorable shocks.The paper thus links two principal components of monetary policy: an interest-rate-based stabilization policy and an optimal long-run inﬂation rate. Assuming aggregate shocks affect agents differently, the inability of some agents to perfectly insure generates an essential role for money and opens up the possibility that monetary policy may improve welfare. Under the optimal policy, the central bank, together with the private banking system, may help insure against unanticipated shocks. 5 POLICY DISCUSSION PAPERS NUMBER 23, DECEMBER 2007 In “The Optimal Inﬂation Target in an Economy with Limited Enforcement,” Gaetano Antinol., Costas Azariadis, and James Bullard formulate the central bank’s problem of The Optimal Inﬂation Target in an Economy with Limited Enforcement selecting an optimal long-run inﬂation rate as the choice of a distorting tax. Households are divided into cash agents who store value in currency alone, and credit agents who Gaetano Antinol., Costas Azariadis, and James Bullard have access to both currency and loans.The planner’s problem is equivalent to choosing inﬂation and nominal rates consistent with a resource constraint, along with an incentive constraint that ensures credit agents do not default on obligations. In this environment, deﬂation may not be feasible since it subsidizes currency at the expense of loans, leading credit agents to default. An inﬂation rate higher than the minimum required to slacken debt constraints is equivalent to a distortionary income transfer from cash agents to credit agents.With a little imagination, one can potentially interpret these ﬁndings as consistent with the “comfort zones” articulated by some central banks. In “Information Aggregation and Central Bank Communication,” Pierre-Olivier Weil and Manuel Amador consider a monetary economy with no explicit microfoundations (they use a cash-in-advance constraint), but model carefully uncertainty about the value of aggregate productivity. Information is initially dispersed among households, and Information Aggregation and Central Bank Communication Pierre-Olivier Weil and Manuel Amador households learn by observing the distribution of nominal prices.This distribution, however, will not fully reveal productivity because prices are affected by the unknown level of the money supply.When the central bank discloses information about money, it has a direct beneﬁcial effect since households can extract more information about productivity. But there is also a countervailing effect: after an announcement, households rely more on public and less on private information, and this tends to reduce the informational content of prices. It is shown show that, in some circumstances, a policy announcement can reduce welfare.Whether this is empirically relevant in practice is an open issue, but it is important to see how these kinds of effects can arise in principle. High-inﬂation economies often experience reductions in quantity and variety in the Inﬂation and Variety marketplace. Previous models explain the ﬁrst phenomenon, but not the second. In “Inﬂation and Variety,” Mei Dong endogenizes the effect of inﬂation on both quantity and variety. Two market structures for decentralized trade are considered: bargaining and competitive search. For both market structures, inﬂation reduces quantity per trade and variety.The bargaining outcome entails a double holdup problem, since ﬁrms make ex ante investments in variety, and consumers make ex ante investments before being matched. The terms of trade are generally inefﬁcient due to both the inﬂation and bargaining distortions. The Friedman rule is the optimal policy but is unable to achieve simultaneously the efﬁcient quantity and variety under bargaining. In contrast, in competitive search equilibrium the Friedman rule achieves the efﬁcient allocation.The model is calibrated and used to measure how much of the welfare cost of inﬂation can be traced back to a reduction of variety, and how much to a reduction in quantity. 6 Mei Dong FEDERAL RESERVE BANK OF CLEVELAND In “Welfare-Improving Departures from the Friedman Rule,” Ed Nosal discusses the following. If a departure from the Friedman rule is to be socially optimal, there must exist some kind of counterbalancing beneﬁt associated with holding a non-interest-bearing asset. The literature has offered some potential beneﬁts. Nosal identiﬁes a new avenue. Welfare-Improving Departures from the Friedman Rule Ed Nosal The basic idea is that if there an option value associated with putting off the purchase of certain kinds of goods, then individuals may be “too choosy” when purchasing these goods. For example, individuals may spend too much time shopping for an illiquid durable, such as a used car, in hopes of ﬁnding a better car tomorrow. Since it is costly to hold money, a non-zero interest rate will make people less choosy in terms of the goods that they purchase, and this, in turn, can increase social welfare. Fiscal and Monetary Policy In models of monetary exchange, where prices are determined by bargaining, output tends to be too low.The introduction of production subsidies is, therefore, a natural idea. In “Optimal Monetary and Fiscal Policies in a Search-Theoretic Model of Monetary Exchange,” Pere Gomis-Porqueras and Adrian Peralta-Alva investigate whether sales taxes and production subsidies, in conjunction with a monetary policy, can restore efﬁciency. They ﬁnd production subsidies, and taxes are able to improve the allocation. There are multiple combinations of taxes, subsidies and (sometimes strictly positive) inﬂation Optimal Monetary and Fiscal Policies in a SearchTheoretic Model of Monetary Exchange Pere Gomis-Porqueras and Adrian Peralta-Alva rates that yield efﬁciency.When government expenditures are positive, the optimal policy must trade off inﬂation with tax distortions. Although the efﬁcient allocation cannot be achieved in this case, there are large welfare gains associated with having good ﬁscal and monetary policies in place. When there is a trade-off between the number of transactions (the extensive margin) and the quantity of goods exchanged in each trade (the intensive margin), the Friedman rule may be suboptimal. However, if the government has additional instruments, such as those associated with ﬁscal policy, the optimality of the Friedman rule may be restored. In “The Optimum Quantity of Money Revisited: Distortionary Taxation in a Search Model of Money,” by Moritz Ritter, a distortionary tax is introduced into a monetary search model.The introduction of an additional policy instrument does not resurrect the optimality of the Friedman rule, since inﬂation plays a special role in altering agents’ search deci- The Optimum Quantity of Money Revisited: Distortionary Taxation in a Search Model of Money Moritz Ritter sions. Deviating from the Friedman rule also increases the effectiveness of sales taxes, because an increase in the tax tightens an already binding money constraint. A growing body of evidence suggests that ongoing relationships between consumers and ﬁrms may be important for understanding price dynamics. In “Optimal Fiscal and Monetary Policy in Consumer Markets,” David Arseneau and Sanjay Chugh investigate whether the existence of such customer relationships has important consequences Optimal Fiscal and Monetary Policy in Consumer Markets David Arseneau and Sanjay Chugh for the conduct of long-run and short-run policy. They explore this question using the 7 POLICY DISCUSSION PAPERS NUMBER 23, DECEMBER 2007 Ramsey framework of optimal policy, in the tradition of Lucas and Stokey. A central result is this: when consumers and ﬁrms are engaged in long-term relationships, optimal inﬂation volatility is very low even though all prices are completely ﬂexible. This ﬁnding contrasts with the standard perception from Ramsey models based on Walrasian markets. Echoing the basic intuition of models based on sticky prices, unanticipated inﬂation in Arseneau and Chugh’s environment causes a type of relative price distortion, which stems from fundamental trading frictions that give rise to long-lived customer relationships. All of this research shows it can be very important to consider how ﬁscal and monetary policies interact and hence ought not be studied only in isolation. Financial Intermediation and Banking In “Financial Deepening, Inﬂation, and Economic Growth,” Aleksander Berentsen and Shouyong Shi develop a general equilibrium framework to analyze the relationship be- Financial Deepening, Inﬂation, and Economic Growth tween the operation of the ﬁnancial system, monetary policy, and growth. The ﬁnancial sector, the innovation sector, and the production sector compete for labor. Hence, chang- Aleksander Berentsen and Shouyong Shi es in policy affect the allocation of time and therefore growth. They ﬁrst investigate the dynamic interactions between ﬁnancial development and growth by analyzing how ﬁnancial innovation affects growth, and, in turn, how growth affects the ﬁnancial system. They then study how inﬂation affects ﬁnancial deepening and growth. They calibrate their model to U.S. data, and perform two quantitative experiments. First, they measure the welfare gains that arise from an exogenous reduction of the cost of intermediation. Second, they assess the welfare effects of a permanent reduction of the inﬂation rate. A number of empirical studies suggest that excessive inﬂation, even if anticipated, impairs the performance of ﬁnancial markets. Researchers have highlighted three regularities: there is cross-section evidence of a negative association between long-run inﬂation and ﬁnancial activities; the marginal impact of inﬂation diminishes rapidly; and there is a discrete drop in activity at high inﬂation levels. In “Inﬂation and Intermediation Frictions,” Gabriele Camera presents a theory of the inﬂation–ﬁnance relationship, whose predictions are consistent with these observations. He adds intermediation to the Lagos and Wright model of money. Some features of Inﬂation and Intermediation Frictions Gabriele Camera his model are: cash is needed to support trade on input and output markets; producers need short-term credit for working capital; and intermediation is costly. He shows how inﬂation, even at modest levels, can degrade the asset transformation process performed by ﬁnancial intermediaries, which can disrupt ﬁnancial and real activities if inﬂation is high. In “Banks, Liquidity Insurance, and Interest on Reserves in a Matching Model of Money,”Valerie Bencivenga and Gabriele Camera introduce banks as in Diamond-Dybvig into Lagos-Wright. Each period, an agent experiences a private shock before entering the decentralized market, which determines if he is a buyer or a seller, and if he is a buyer, 8 Banks, Liquidity Insurance, and Interest on Reserves in a Matching Model of Money Valerie Bencivenga and Gabriele Camera FEDERAL RESERVE BANK OF CLEVELAND whether marginal utility is high or low.A bank is a coalition of agents that accepts deposits in the centralized market, holds some reserves of cash to meet withdrawal demand in the decentralized market, and invests the rest. Agents alter their money holdings by making withdrawals in the decentralized market at a ﬁxed cost. Since banks cannot observe the realization of the shocks, bank contracts must be incentive compatible. Banks improve welfare if the cost of withdrawals is not too large. When the cost is small the optimal deposit contract allows agents to achieve the allocation in the decentralized market they would have chosen if they had known the realization of shock prior to choosing their asset position. In “The Venture Capital Cycle,” Rafael Silviera and Randall Wright propose a model The Venture Capital Cycle of private equity, which builds on recent developments in search theory. First they describe how the venture capital market is in reality characterized by the following cycle: Rafael Silviera and Randall Wright (i) ﬁrst capitalists raise funds; (ii) capitalists and entrepreneurs match over time, and decisions are made as to which projects get funding; (iii) after matching, both parties take active roles in implementation; (iv) when eventually a project matures, capitalists take their proﬁts and leave to start the cycle anew.The authors model this rigorously yet with an eye toward a realistic description of institutional details. They analyze various margins, including entry by capitalists, the ﬂow of funds into the market, the decisions to start new ventures, and investment in the project during implementation.They study the duration of each phase in the cycle and the returns to the parties.The model is tractable, and it is easy to prove strong results concerning existence, comparative statics, etc. The implications for policy on this market are discussed. This is part of a large recent body of research trying to integrate ﬁnance with search-theoretic models in macro and monetary economics. Jonathan Chiu and Cesaire Meh, in “Banking, Liquidity and Inﬂation,” extend the analysis of Silviera and Wright by considering the role that ﬁnancial intermediaries may play in the funding of projects.They show that ﬁnancial intermediation improves the allocation but the welfare effects depend on monetary policy. For low inﬂation, intermediation is not useful; for moderate inﬂation rates, it is useful to individuals but actually reduces aggregate welfare; and for high inﬂation intermediation improves aggregate welfare. Absent ﬁnancial intermediaries, capitalists need to bring liquidity to the market to purchase ideas for new projects. Since innovators who sell ideas have random reservation prices, Banking, Liquidity and Inﬂation Jonathan Chiu and Cesaire Meh some entrepreneurs end up with too much liquidity and others end up with too little. This problem is mitigated by having an intermediary that channels funds across entrepreneurs. Banking panics have been associated with price declines in both the United States and Japan. Fisher hypothesized that banking panics are a consequence of mismatches in bank balance sheets, where liabilities are nominal and assets are real. Because of this, a decrease in the price level raises the real value of existing nominal obligations but has 9 POLICY DISCUSSION PAPERS NUMBER 23, DECEMBER 2007 no effect on the real value of assets and, hence, decreases bank value. In “Banking and Intermediation,” Francesca Carapella develops a model to analyze this hypothesis. In the model banks play two roles: they lend to ﬁrms, and they contribute to the payment system by providing an alternative to outside money. If banks default, this alternative is lost and all purchases must be in cash. In this event, the demand for cash increases and, consequently, prices fall. Carapella shows that there exists an equilibrium that features lower prices when banking panics and defaults occur. The environment is suitable for analyzing policy similar to that suggested by Friedman and Schwartz, whose insight was that during the Depression looser monetary policy may have helped. In “Moneychangers and Commodity Money,” Vincent Bignon and Richard Dutu address the issue of the imperfect recognizability in a commodity money system. They construct a model that has light and heavy metal coins, imperfect recognizability, and a technology that enables agents to have their coin assessed and certiﬁed. They show Moneychangers and Commodity Money Vincent Bignon and Richard Dutu that such a technology reduces the set of equilibria where heavy coins are not traded when they are not recognized as heavy, a version of Gresham’s law.Also, they show that Gresham’s law and certiﬁcation cannot coexist as equilibria. They show that welfare is higher when heavy coins are certiﬁed.The technology also restricts the set of equilibria characterized by circulation of light and heavy coins trading at the same price when not recognized. However, circulation-by-tale survives for high discount rates. This kind of work not only aids our understanding of historical episodes, it also helps us to think about modern issues like the possibility or desirability of private monies. There are numerous historical episodes in which individuals complained about there being a shortage of small coins. The lack of small change appears to have caused the following problem. In order to complete a purchase, a buyer has to pay too much or forgo the transaction altogether. In “A Model of Small-Change Shortages,” Angela Redish and Warren Weber build a matching model with two indivisible commodity monies. This takes seriously the idea that monies are coins with different intrinsic values. Both the case in which the supplies of silver and gold available for coinage are ﬁxed and the A Model of Small-Change Shortages Angela Redish and Warren Weber case in which minting and melting are permitted are examined. For the case in which the supplies of the two metals are ﬁxed, there exist equilibria in which both monies are used for trades and the lower-valued money is used to make change in some transactions. Increasing the supply of small coins can improve welfare.These ﬁndings are consistent with the historical complaints about small-change shortages, and, again, also help us to think about modern issues in monetary economic theory and policy. Self-regulatory organizations, or SROs, play an important role in the securities industry.While self-regulation is viewed as having advantages over direct regulation, this view can be questioned. The incentive to self-regulate may be reduced as competition for listing and trading volume among organizations (exchanges) increases. In “Competition among Exchanges and Enforcement Policy,” Cecilia Caglio and Andrea Pescatori explore 10 Competition among Exchanges and Enforcement Policy Cecilia Caglio and Andrea Pescatori FEDERAL RESERVE BANK OF CLEVELAND this idea. They ask whether the presence of multiple for-proﬁt SROs results in lax selfregulation as a means of attracting business, and what effect enforcement policy has on the division of rents.A costly-state-veriﬁcation model is developed where SROs compete by setting enforcement policy and transaction fees. Transactions are executed by brokers, but investors do not observe cash ﬂow, and brokers try to minimize payments by misreporting true ﬂows. An investigation can occur when a transaction takes place, and the likelihood of a successful investigation depends upon the amount of resources invested and the efﬁciency of monitoring. If fraud is detected, the SRO imposes a penalty on the broker. It is shown that competition among for-proﬁt SROs generates a “race to the bottom” for enforcement, which ultimately reduces SRO proﬁts and increases broker proﬁts. Money and Bonds When agents face binding cash constraints, the introduction of illiquid bonds may improve the monetary allocation. In “The Societal Beneﬁts of Outside versus Inside Bonds,” Aleksander Berentsen and Christopher Waller study the case in which the allocations of illiquid outside bonds and inside bonds are different, and examine optimal policy.A model in the spirit of Lagos and Wright is constructed with money and bonds.Two economies The Societal Beneﬁts of Outside versus Inside Bonds Aleksander Berentsen and Christopher Waller are considered: one with illiquid government bonds and one with inside bonds. Consumers receive preference shocks, which create differential needs for liquidity; after shocks occur but before goods markets open, they trade bonds and money. It is assumed that the government cannot run a deﬂation since this requires lump-sum taxation. It implies that, with inside bonds, redemption must be voluntary. It is shown that for any positive inﬂation rate, bonds are essential in both economies. For sufﬁciently high inﬂation rates, the allocations in the two economies are the same, while they differ for low inﬂation rates. The key result is that, under an optimal policy, the allocation with illiquid outside bonds dominates the allocation with inside bonds. In “Sustained Societal Beneﬁt of Illiquid Bonds,” Ling Sun also studies whether allocative efﬁciency can be improved by introducing illiquid bonds. Households are heterogeneous, which creates a need for intratemporal consumption smoothing. Since consum- Sustained Societal Beneﬁt of Illiquid Bonds Ling Sun ers and producers from the same households go to different locations to participate in market activities, money is essential to facilitate trade. When bonds are perfectly liquid, they are perfect substitutes for money and, hence, their rates of return are the same. The allocation in this case is not efﬁcient since marginal utilities of consumers are not equated. Introducing illiquid bonds enables households to engage in intratemporal consumption sharing. Introducing illiquid bonds generates an improvement in efﬁciency in two ways: by better allocating consumption goods among heterogeneous agents, and by stimulating output by loosening liquidity constraints. 11 POLICY DISCUSSION PAPERS NUMBER 23, DECEMBER 2007 Much of what passes for money in any well-developed economy is private debt. An almost universal property of private debt instruments is that they are collateralized by some form of capital. It would seem desirable to study environments in which capital can be used to collateralize private debt and collateralized debt can serve as a means of payment.The challenge would be to explain why .at money remains essential, and why agents make good on debt contracts. To this end, in “Money, Capital, and Collateral,” Da- Money, Capital, and Collateral vid Andolfatto and Fernando Martin employ a simple assumption that agents can commit to honor debt only up to some value related to their accumulated stock of capital. David Andolfatto and Fernando Martin When constraints are slack, money is inessential.When collateral constraints bind, however, money expands the set of feasible trades. Away from the Friedman rule, both private debt instruments and .at money are essential, with both assets earning an identical return. Hence, when collateral constraints bind, there is an insufﬁcient supply of private money. Collateral constraints become less important at lower rates of inﬂation. In “Collateral Secured Loans in a Monetary Economy,” Leo Ferraris and Makoto Watanabe also present a model where anonymous agents use capital goods as a guarantee of repayment. The environment is a version of Lagos-Wright with a competitive credit market. Since monitoring or enforcement is unavailable, agents can obtain loans only by Collateral Secured Loans in a Monetary Economy Leo Ferraris and Makoto Watanabe committing capital as collateral. Two situations can arise in equilibrium: one is where the borrowing constraint does not bind, and capital is at the ﬁrst-best level; the other is where the constraint binds, and capital is too high.The effect of inﬂation on investment is determined by the marginal net beneﬁt of making a loan relative to that of money holdings. They show, for example, that capital accumulation is decreasing in the rate of inﬂation if and only if relative risk aversion is below unity. In “Optimal Risk-Sharing without Commitment in a Model where Money and Collateral are Essential,” David Mills and Robert Reed provide an environment in which collateral arises endogenously, alongside money, to support trade.The new twist is that collateral serves two roles: the ﬁrst is to provide incentives for borrowers to pay back loans; Optimal Risk-Sharing without Commitment in a Model where Money and Collateral are Essential David Mills and Robert Reed and the second is to provide insurance for lenders in the event that borrowers default. In order to have both roles, the environment adopts the following features. There are two types of agents, who differ in preferences, endowments, and investment technologies, motivating the need for credit. In order to capture the incentive role for collateral, agents cannot commit to future actions. A tension between two incentive constraints pins down the optimal amount of collateral, such that borrowers with the ability to repay are just indifferent between defaulting or not, while lenders are indifferent between selling the collateral back and liquidating. In “On the Term Structure of Real Interest Rates and Inﬂation: Empirical Evidence using Inﬂation Forecasts,” Joseph Haubrich, George Pennacchi, and Peter Ritchken develop and test a four-state-variable model of the dynamics of the term structure. The state variables correspond to a real interest rate, expected inﬂation, inﬂation volatility, 12 On the Term Structure of Real Interest Rates and Inﬂation: Empirical Evidence using Inﬂation Forecasts Joseph Haubrich, George Pennacchi, and Peter Ritchken FEDERAL RESERVE BANK OF CLEVELAND and a stochastic central tendency to which the inﬂation rate reverts. Expected inﬂation, its central tendency, and the real rate follow correlated mean-reverting processes whose volatilities are proportional to the volatility of inﬂation. In turn, actual inﬂation follows a correlated GARCH process. Analytical solutions for the term structure of nominal bond prices are developed.Analytical solutions for prices of inﬂation-indexed bonds that have an indexation lag, such as U.S. Treasury Inﬂation-Protected Securities, are derived. The model can use survey forecasts of inﬂation, together with price indices and nominal bond yields, to establish a coherent model of the dynamics of the term structure. It also can be used to obtain estimates for real rates, for long rate changes, and so on, and is rich enough to price Treasury Inﬂation-Protected Securities, including the indexation lag. 13 POLICY DISCUSSION PAPERS NUMBER 23, DECEMBER 2007 Papers Presented at the Summer Workshop on Money, Banking, and Payments August 6–17, 2007 Foundations Stationarity and Degeneracy in a Commodity Money Model Ricardo Cavalcanti and Daniela Puzzello Competing Auctions in a Monetary Economy* Richard Dutu, Benoit Julien, and Ian King Counterfeiting as Private Money in Mechanism Design Ricardo Cavalcanti and Ed Nosal On the Uniqueness of Steady-State Monetary Equilibrium in the Alternating Market Model of Money Randy Wright A Hotelling Model with Money* Dean Corbae and Borghan N. Narajabad One Money or Two Monies? Mei Dong and Janet Hua Jiang Markets and Relationships in a Learning Economy* Luis Araujo and Raoul Minetti Central Banking and Monetary Policy Optimal Central-Bank Intervention: An Example Alexei Deviatov and Neil Wallace Adverse Selection and the Role of Monetary Policy* Daniel Sanches and Steve Williamson Public Information and Monetary Policy* Marie Hoerova, Cyril Monnet, and Ted Temzelides Central Bank Design with Heterogeneous Agents Alex Berentsen and Carlo Strub Uncertainty, Inﬂation, and Welfare Jonathan Chui and Miguel Molico Elastic Money, Inﬂation, and Interest Rate Policy Allen Head and Junfeng Qiu The Optimal Target in an Economy with Limited Enforcement Gaetano Antinolﬁ, Costas Azariadis, and James Bullard Information Aggregation and Central Bank Communication Pierre-Oliver Weil and Manuel Amador Inﬂation and Variety Mei Dong Welfare-Improving Departures from the Friedman Rule Ed Nosal 14 FEDERAL RESERVE BANK OF CLEVELAND Fiscal and Monetary Policy Optimal Fiscal and Monetary Policies in a Search-Theoretic Model of Monetary Exchange Pere Gomis-Porqueras and Adrian Peralta-Alva The Optimum Quantity of Money Revisited: Distortionary Taxation in a Search Model of Money* Moritz Ritter Optimal Fiscal and Monetary Policy in Customer Markets* David Arseneau and Sanjay Chugh Financial Intermediation and Banking Financial Deepening, Inﬂation, and Economic Growth Aleksander Berentsen and Shouyong Shi Inﬂation and Intermediation Frictions Gabriele Camera Banks, Liquidity Insurance, and Interest on Reserves in a Matching Model of Money Valerie Bencivenga and Gabrielle Camera The Venture-Capital Cycle Rafael Silviera and Randy Wright Banking, Liquidity, and Inﬂation Jonathan Chui and Cesaire Meh Banking and Intermediation* Francesca Carapella Moneychangers and Commodity Money* Vincent Bignon and Richard Dutu A Model of Small-Change Shortages* Angela Redish and Warren Weber Competition among Exchanges and Enforcement Policy Cecilia Caglio and Andrea Pescatori Money and Bonds The Societal Beneﬁts of Outside versus Inside Bonds* Aleksander Berentsen and Christopher Waller Sustained Societal Beneﬁt of Illiquid Bonds Ling Sun Money, Capital, and Collateral* David Andolfatto and Fernando Martin Collateral-Secured Loans in a Monetary Economy* Leo Ferraris and Makoto Watanabe Optimal Risk-Sharing without Commitment in a Model where Money and Collateral Are Essential David Mills and Robert Reed On the Term Structure of Real Rates and Inﬂation: Empirical Evidence Using Inﬂation Forecasts Joseph G. Haubrich, George Pennacchi, and Peter Ritchken *posted on http://www.clevelandfed.org/research/conferences/2007/august/index.cfm. 15 pd papers Presorted Standard FEDERAL RESERVE BANK OF CLEVELAND RESEARCH DEPARTMENT P.O. BOX 6387 U.S. Postage Paid Cleveland, OH Permit no. 385 CLEVELAND, OHIO 44101 Return Service Requested: Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, Ohio 44101.