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Federal Reserve Bank of Chicago

Summer Workshop on Money,
Banking, Payments and Finance:
An Overview
Ed Nosal and Randall Wright

November 23, 2010
WP 2010-15

Summer Workshop on Money, Banking,
Payments and Finance: An Overview
Ed Nosal
Federal Reserve Bank of Chicago
Randall Wright
University of Wisconsin
and Federal Reserve Bank of Minneapolis
November 23, 2010
Abstract
The 2010 Summer Workshop on Money, Banking, Payments and Finance
met at the Federal Reserve Bank of Chicago this summer, for the second
year. The following document summarizes and ties together the papers
presented.

1

Introduction

The annual Summer Workshop on Money, Banking, Payments and Finance met
again in August 2010. The theme once again was on institutions that facilitate the exchange process, including money, credit, banks, asset markets, and
related topics. Most of the work uses the branch of economic theory recently
dubbed New Monetarist Economics in surveys by Stephen Williamson and Randall Wright (2010a, 2010b), and extensively described in the book by Ed Nosal
and Guillaume Rocheteau (2011). The goal in this framework is to take microfoundations of the exchange process seriously, as opposed to resorting to ad hoc
shortcuts (such as imposing cash-in-advance constraints or inserting money into
utility functions), or simply ignoring institutions meant to facilitate exchange
(as in most New Keynesian models). This …eld of research is extremely active
and many papers have been making progress in terms of our understanding of
basic theory, our development of applications, including policy analysis, and our
understanding of the evidence.
This year 32 papers were presented. These can be broadly grouped into six
broad topics: liquidity, which is the ability to quickly buy or sell assets (or other
objects) with a short delay and at a low cost; …nancial intermediation, with a focus on the roles of banks; international economics, which examines issues related
to money, capital, liquidity and exchange rate determination in an international

1

context; history, which tries to understand interesting economic episodes in the
past through the lens of modern theory; information, which involves modeling information asymmetries that characterize, for example, over-the-counter
markets and …nancial markets, in general; and theory, which involves work on
relatively deep issues related to money, banking, payments or …nance. Here we
summarize and to some extent try to consolidate the individual contributions.

2

Liquidity

The last two U.S. recessions were preceded by rapid increases, followed by abrupt
collapses, in some asset prices. These events have suggested to many that asset
prices can rise above levels justi…ed by fundamentals, and that price corrections
can trigger or amplify economic ‡uctuations, with important consequences for
the macroeconomy. When and how can economic models generate this type of
asset price behavior as an equilibrium outcome? This issue is nontrivial since
generating such asset price dynamics is not easy in standard models. In “Liquidity and Asset Price Dynamics,” Guillaume Rocheteau and Randall Wright
study an economy with an essential role for liquid assets. The model can generate multiple stationary equilibria, across which asset prices, participation, stock
market capitalization, output and welfare are positively related. Even when
fundamentals are deterministic and time invariant, there can be a variety of
non-stationary equilibria. This includes equilibria with price trajectories that
resemble bubbles growing and bursting, as well as periodic, chaotic, and stochastic (sunspot) equilibria with recurrent market crashes. The issue of optimal
liquidity provision is also examined. This paper extends the class of models we
can use to help understand dynamic asset markets and the role of liquidity.
During …nancial crises, many asset prices plummet, destroying their liquidity
provision function at the worst time. These …re sales appear to be at the core
of the ampli…cation mechanism and credit crunch observed in some crises. How
can this occur in deep …nancial markets, such as those in the U.S. where a
large number of potential buyers should have the resources to arbitrage …re
sales? In “Fire Sales in a Model of Complexity,” Ricardo Caballero and Alp
Simsek propose a model in which the answer builds on the idea that complexity
becomes a central concern during crises. The basic structure of their model
is that of a …nancial network that is susceptible to contagion and cascades.
During normal times, banks only need to understand the …nancial health of
their trading partners, which they can learn at low cost. In contrast, when
a signi…cant problem arises in a part of the network, and the possibility of
cascades arises, it is not enough to be informed about these partners. It is also
important to learn about the health of their trading partners. As conditions
deteriorate, banks must learn about the health of the trading partners of the
trading partners of their trading partners, and so on. Eventually, the problem
becomes too complex to fully …gure out, which means banks face signi…cant
uncertainty. This rise in uncertainty makes relatively healthy banks, and hence
potential asset buyers, reluctant to buy. This is help in understanding how

2

liquidity in the market can quickly vanish.
A sharp decline in the volume of new issuances in the U.S. secondary loan
market has resulted in a variety proposals intended to restore the “normal”functioning of this market. In “Adverse Selection, Reputation and Sudden Collapses
in Secondary Loan Markets,”V.V. Chari, Ali Shourideh, and Ariel Zetlin-Jones
analyze why new issuances might abruptly collapse. The main economic function of the secondary loan market is to allocate originated loans to individuals
and institutions that have a comparative advantage in holding or managing
these loans. This function can be disrupted by informational frictions. In particular, an adverse selection problem arises since loan originators di¤er in their
ability to originate high-quality loans, and are better informed about this ability
than potential purchasers. Reputational considerations can either ameliorate or
intensify this problem. The model has fragile outcomes in which sudden collapses in the volume of new issuances are associated with increased ine¢ ciency.
Reductions in collateral values worsen the adverse selection problem and induce
some potential sellers to hold on to their loans. Reputational incentives induce
a large fraction of potential sellers to hold on to their loans rather than sell them
in the secondary market. As a result, a small reduction in collateral value can
cause a large number of originators to hold their loans, leading to a collapse in
new issuances. The authors discuss a variety of interest rate and loan purchase
policies.
In a similar vein, the crisis has forced governments or central banks to heavily intervene in …nancial markets that were impaired by risk and uncertainty. In
“Market Freeze and Recovery: Trading Dynamics under Optimal Intervention
by a Market-Maker-of-Last-Resort,”Jonathan Chiu and Thor Koeppl study how
a …nancial market where trading has ceased reacts to intervention by a large
player. They analyze the optimal design of intervention as a crisis is unfolding.
In the context of a search model with adverse selection, they demonstrate that
trading of a …nancial asset can cease when its average quality drops su¢ ciently,
or when trading frictions increase su¢ ciently. A large player like a central bank
can re-establish trading if he removes a large quantity of bad assets. This involves assuming losses. They show that such a player does not have to intervene
immediately: an announcement today of future intervention can cause markets
to rebound. This announcement e¤ect gives rise to a trade-o¤ between the size
and timing of interventions. The optimal policy balances the cost of transfers
against the cost of illiquidity. If the former are small, it is optimal to ensure that
markets function continuously. This is achieved by intervening immediately, but
at a minimum scale. When the costs of transfers increase, it is better to delay
intervention and increase its size. Furthermore, if the central bank is required to
maintain continuously functioning markets, they show that the optimal policy
is to intervene immediately after the shock, but at the minimum scale that is
required to resurrect the market. This is in stark contrast to the literature that
analyzes optimal market making in the face of pure liquidity shocks.
If …nancial market participants lack commitment, capital can be valued for
its ability to facilitate intertemporal trade. For example, capital is frequently
used as collateral in support of debt. Most of the time, private instruments work
3

tolerably well in facilitating payments. There are recurring episodes, however,
when the system is disrupted by a decline in the value of capital. In “Money
and Capital in a News Economy,”David Andolfatto and Fernando Martin interpret such episodes as the consequence of “bad news”that lowers the conditional
forecast of future capital returns. Government policy designed to subsidize capital in depressed conditions has an ambiguous impact on welfare. On the one
hand, such a policy eases credit conditions. On the other hand, it promotes
overaccumulation of capital goods that are used for collateral. They also investigate the desirability of other interventions in the payments system. The
model suggests the desirability of government money or debt for use in payments. While this conclusion is not new, the rationale o¤ered is novel. In a
stochastic economy with limited commitment, even risk-neutral traders have a
preference for assets that exhibit “value preservation”over short horizons. One
bene…t of government money or debt is that its value is not tied directly to any
underlying capital object, so it may be less sensitive to “news.” This suggests
that government debt is valued in the payments system because it may retain
its value in depressed conditions.
During the recent …nancial crisis, policy makers introduced a number of
new tools to address the apparent lack of liquidity in …nancial markets. In
“Optimal Liquidity Policy,”Jennifer Huang and Jiang Wang construct a simple
theoretical framework to examine issues associated with policy intervention. In
their environment liquidity provision is ine¢ cient in the market equilibrium,
in both an ex ante and ex post sense. The ine¢ ciency arises because agents
are unable to pro…tably capture the entire externality associated with liquidity
provision. They demonstrate that policy interventions that resemble those that
we saw during the recent crisis often have limited or undesirable e¤ects. They
propose a constrained optimal liquidity policy.

3

Financial Intermediation

How are publicly- and privately-provided liquidity important for exchange in
…nancial markets? How does monetary policy matter for in‡ation and real allocations, through its e¤ects on exchange and intermediation? In “Liquidity,
Financial Intermediation, and Monetary Policy,”Stephen Williamson addresses
these questions in a model that integrates elements of received banking and
monetary theory. In contrast to standard approaches, open market operations
need not be neutral, even in the long run. This is because a one-time open
market purchase of nominal government debt reduces the supply of public liquidity backing intermediary claims used in …nancial markets. The real interest
rate falls, re‡ecting asset scarcity, and this increases intermediary lending and
output. The model shows how …scal policy (active or passive) matters, and illustrates how the costs of operating a currency system matter for the determination
of an optimal in‡ation rate. Some examples show the e¤ects of a …nancial crisis
on the economy, and how policy should respond. Monetary policy works quite
di¤erently when banks are holding excess reserves. In that case, the interest

4

rate on reserves determines all other interest rates, and open market operations
are irrelevant. A liquidity trap can occur for any in‡ation rate, given the appropriate monetary policy, not just at the Friedman rule. This is a …ne example
of getting new insights about critical policy issues by using modern monetary
theory.
In related work, “Liquidity, Asset Prices, and Credit Constraints,”by YingSyuan Li and Yiting Li, the implications are examined for asset prices and
borrowing in an economy with limited commitment, enforcement and record
keeping. Banks provide a socially bene…cial role by channelling funds from
people with idle liquidity to those with needs to …nance consumption. Because
banks o¤er loan contracts that allows agents to borrow only as much as they have
an incentive to repay, credit constraints endogenously emerge. The relationship
between asset prices, aggregate liquidity and allocations are characterized. An
asset will command a liquidity premium when credit constraints bind, and the
premium is higher when credit rationing is more severe. Monetary policies can
in‡uence macroeconomic outcomes through the credit channel, and the precise
e¤ects depend on the technology to deter default. If exclusion from future
credit is feasible, aggregate liquidity and output may rise with in‡ation, because
in‡ation raises the cost of losing the access to future credit. Even though the
asset price is reduced by in‡ation, liquidity may be increased because of higher
loan-to-value ratios. The asset price is reduced by in‡ation since money and real
assets, which are used as collateral, are complements. This is in contrast to most
of the literature, in which money and other assets are substitutes. This paper
thus greatly enhances our understanding of the relationship between money and
asset prices.
Continuing on the theme of intermediation, most theories of banking crises
focus on the case where contracts are written in real terms, so “liquidity”means
the availability of a physical good that can be used for consumption or investment. There is, therefore, a real opportunity cost to providing liquidity to
the …nancial system. In practice, however, …nancial contracts are almost always written in nominal terms. The possibility of nominal contracts potentially
makes a signi…cant di¤erence because it means that the central bank can costlessly create money to deal with a crisis. In “Money, Financial Stability and
E¢ ciency,” Franklin Allen, Elena Carletti and Douglas Gale use a standard
banking model but with nominal rather than real contracts. They show that
the combination of nominal contracts and a central bank that accommodates
commercial banks’ demand for liquidity leads to e¢ ciency. This implies there
are no …nancial crises even when liquidity demands are high or asset returns
are low. The e¢ ciency result holds with aggregate and idiosyncratic liquidity
shocks, as well as aggregate and idiosyncratic uncertainty about asset returns.
Although the assumption of nominal contracting perhaps requires some more
justi…cation, it is important to know the implications.
In “Liquidity Transformation and Bank Capital Requirements,”Hajime Tomura presents a dynamic general equilibrium model of banking, where liquidity
transformation and bank capital requirements arise endogenously. New real assets are produced from goods, and the fraction of agents that can produce them
5

must sell existing assets in a secondary market to …nance purchases of goods
needed to produce new assets. Adverse selection in the secondary market means
potential producers of new assets are discouraged from selling high-quality assets. As a result, they purchase and invest less. The market’s undervaluation
or illiquidity of assets leads to a demand for liquid assets. Banks can meet
this demand since they can issue liabilities backed by assets from the secondary
market. Bank liabilities are priced fairly since the idiosyncratic qualities of real
assets held by a bank average out. The existence of these liabilities increases
liquidity. However, the secondary market price for real assets is reduced. The
model shows that if the business cycle is driven by productivity shocks, then
‡uctuations in the capital-asset ratio of banks are pro-cyclical, but they are
counter-cyclical if a rise in heterogeneity of asset quality increases the illiquidity
of real assets in the competitive secondary market for real assets. This work
is pointing us in the right direction in terms of understanding secondary asset
markets.

4

International

Several papers applied modern monetary theory to study international economic issues. For example, in response to a global dollar shortage in the recent
crisis, the Fed injected dollar liquidity into the international …nancial system.
Empirical studies of the success of these e¤orts have yielded mixed results because it is di¢ cult to disentangle the e¤ects of policy from those of news about
fundamentals. In “Dollar Illiquidity and Central Bank Facilities During the
U.S. Sub-Prime Crisis,” Andrew Rose and Mark Spiegel develop a model of
dollar illiquidity. In their model, assets are valued for both their returns and
liquidity services. When the liquidity of an asset declines (say, toxic American mortgage-backed securities), the model predicts that the dollar appreciates
since the demand for close substitutes increases through a “‡ight to liquidity.”
The theory suggests that nations with more exposure to the US are likely to
be more sensitive to global capital injections, such as the term auction facilities
conducted by the ECB and others. Although the preliminary evidence is mixed,
some auctions appear to yield results in line with their theory.
Another issues in international economics is this. Even though low in‡ation rate international currencies are increasingly available in most economies,
domestic currencies remain the dominant means of payment in most countries.
This observation seems to contradict the literature on currency competition,
which predicts that in absence of transaction costs agents will use the less in‡ationary currency. In “In‡ation, Debt Enforcement and Currency Competition,”
Mariana Rojas Breu constructs a framework in which higher in‡ation currencies
are used despite the availability of a lower in‡ationary currency and the absence
of transactions costs. The model is a standard monetary economy with banks,
where a key assumption is that debt enforcement is not perfect. Under certain
conditions, the in‡ation rate of a currency in which debts are denominated may
function as a commitment device. A higher in‡ationary currency can be used in

6

equilibrium since the punishment for defaulters (who avoid market transactions)
will be higher if the currency in which they borrow is more in‡ationary. That is,
there will be a smaller bene…t associated with defaulting on debt that is written
on the more in‡ationary currency. Lending agents anticipate that borrowers
are able to better commit to repaying their loans the more in‡ationary is the
currency. As a result, banks are willing to hold a more in‡ationary currency.
This is a novel spin on a topical issue.
A related issue is this. Over the past decade, OECD countries have held
nearly three quarters of their wealth in domestic assets. This is at odds with
standard frictionless models that predict risk averse agents will insure away
country-speci…c risks by holding a portfolio of international assets. A large
literature has tackled this “home bias”puzzle by examining frictions that limit
the ability of agents to diversify internationally. In “Asset Liquidity and Equity
Home Bias,”Thanasis Geromichalos and Ina Simonovska attempt to rationalize
this puzzle through a mechanism that links home bias to liquidity. The concept
of asset liquidity arises when assets can serve a duel role: they are claims to
future consumption and means of payments. If there are better opportunities
to trade in domestic than foreign decentralized markets, agents will have a
greater demand for home assets. Since agents hold more domestic assets, they
bring more of these assets to domestic markets and exchange them for larger
quantities of goods. Hence, asset home bias also generates consumption home
bias, as in the data. The authors have a promising framework for future work
in the area.
In “Goods Market Frictions and Real Exchange Rate Puzzles” Qing Liu
develops a two-country dynamic search model with fully ‡exible price. His
approach deviates from the literature, which relies on the interaction of nominal
price rigidities and monetary shocks. His goods market is decentralized and
modeled using random bilateral matching. Search frictions in markets generate
a di¤erential in a household’s valuations of two currencies, and results in a
deviation from the law of one price at both the disaggregate and aggregate
levels. Quantitative results suggest that deviations from the law of one price
contribute to the majority of the ‡uctuations in exchange rates observed in the
data. Moreover, the model performs well quantitatively with respect to two
other stylized facts: changes in real exchange rates are highly persistent; and
there are systematic changes in the volatility of real exchange rates when there
is a switch of exchange rate regimes. This is another promising framework for
future work in international economics.
Similarly, in “Money, Capital and International Exchange Rate Fluctuations,”Pere Gomis-Porqueras, Timothy Kam and Junsang Lee examine whether
a ‡exible price, two-country, search model of money can account for empirical
regularities in U.S. real and nominal exchange rate dynamics. In the data, the
real and nominal exchanges rates are more volatile than GDP, are highly persistent, and are highly positively correlated. The authors use a two-country
version of the Lagos-Wright model, where capital is a productive input for sellers in the decentralized market. There are two mechanisms at work that help
amplify and propagate international shocks: the monetary friction, and capital
7

accumulation. The monetary friction can be controlled by introducing an exogenous probability that agents in decentralized trade may be in one two kinds
of trades, anonymous monetary trades or monitored credit trades. If the monetary friction is shut down by having only credit trades, the authors show that
the model cannot account for the facts on exchange rates. However, if a small
proportion of trades are anonymous— so agents must use money— then aggregate relative prices are relatively non-volatile and persistent. This contributes
to the excess volatility and persistence in the real and nominal exchange rate.
Thus, without exogenous price-stickiness, the model rationalizes the correlation
between real and nominal exchange rate.
In “Heterogeneity and the Welfare Cost of In‡ation: An International Perspective,” Paola Boel quanti…es the welfare cost of anticipated in‡ation in a
model with equilibrium dispersion in wealth and earnings. The model is calibrated to several OECD economies, including Australia, Austria, Canada,
France, Italy, Spain and the U.S. In all economies, except Australia, a representative agent would give up only a fraction of 1% of consumption to avoid
10% in‡ation. Even if in‡ation does not generate large losses in societal welfare,
she …nds that in all countries considered, in‡ation has signi…cant redistributive
e¤ects. Moreover, such redistributive e¤ects vary depending on the …nancial
assets present in the economy. If money is the only asset, then in‡ation hurts
the wealthier agents, while those poorer bene…t from it. The opposite is true
if agents can insure against consumption risk with other assets. This is a nice
further step towards understanding the role of monetary policy not just in the
U.S. but in other countries.

5

History

Several papers look at money and …nancial institutions from the historical perspective. In “How Amsterdam Got Fiat Money,” Stephen Quinn and William
Roberds investigate the system introduced by the Bank of Amsterdam in 1683.
Using data from the Amsterdam Municipal Archives, they partially reconstruct
changes in the bank’s balance sheet from 1666 through 1702. Their calculations
show that the Bank of Amsterdam, which was founded in 1609, engaged in two
archetypal central bank activities— lending and open market operations— both
before and after its adoption of a …at standard. These activities were made
possible by the bank’s (near) monopoly on large-value payments within the
city of Amsterdam. After 1683, however, the bank was able to conduct more
aggressive policy interventions. To ease seasonal credit pressures, the bank routinely extended large loans to the East India Company, and it also bought and
sold signi…cant quantities of precious metal in order to stabilize the value of its
money. The bank’s successful management of a …at standard foreshadows later
developments in the history of central banking.
Prior to the U.S. Civil War, several states established bank liability insurance
schemes of two basic types. One was an insurance fund, in which member
banks paid into a state-run fund that would pay losses of bank creditors. The

8

other was a mutual guarantee system, in which survivor banks were legally
responsible the liabilities of any bank that became insolvent. In “Bank Liability
Insurance Schemes Prior to 1865,”Warren Weber argues that both schemes did
well at insuring bank creditors, but neither prevented bank panics. In fact, bank
failure rates were somewhat higher for banks that were part of these schemes.
The experience with these schemes shows that regulatory incentives matter for
controlling moral hazard, obviously an important message for contemporary
economies as well. The schemes that provided the most control of moral hazard
were those that had a high degree of mutuality of losses borne by all banks
participating in the scheme.
In “Mechanism Design and Commodity Money,” Richard Dutu and Chingjen Sun propose a model where pro…t-maximizing mints design menus of coins
for buyers. Buyers purchase coins from mints and use them to buy goods from
sellers. Coins di¤er in two dimensions: by their weight (or …neness), which
re‡ects an intrinsic quality, and by their seigniorage fee (the mint’s revenue).
Two di¤erent market structures are examined: In one, the supply of coins is
controlled by a monopoly, while in the other it is determined by in competitive
market. The model o¤ers answers to several puzzles associated with commodity
money systems, such as the lack of small change, the unappealing denomination
structure and variations in seigniorage rates across coins. For example, when the
mint has a monopoly over the supply of coins, they show that the menu of coins
o¤ered to buyers is characterized by ine¢ ciently small low-denomination coins
and by seigniorage rates that are higher on small coins. When the proportion of
low-valuation buyers is too small, it is optimal for the mint to o¤er large coins
only, hence, the lack of small change. Like the rest of these papers on historical
issues, this one is useful for thinking about modern economies as well.

6

Information

The next group of papers concern informational frictions. This is potentially a
very important area of research on asset markets, where it can be di¢ cult for
traders to know the quality of some securities. Especially since the recent …nancial crisis, it seems necessary to understand how asset markets function with
adverse selection. Veronica Guerierri, Robert Shimer and Randall Wright, in
“Equilibrium in Dynamic Asset Markets” assume buyers may be less informed
about the return on an asset. This may a¤ect the price of assets, and moreover,
informational frictions imply that it may take a longer time to trade, which
means liquidity is a¤ected. A big issue that comes up in modeling asset markets with private information is this: what mechanism determines the terms of
trade? The authors use price posting with directed search, also known as competitive search equilibrium. They …rst extend their earlier work on competitive
search equilibrium with adverse selection from static to dynamic environments.
They then use the model to analyze equilibria in asset markets with private
information. A key insight is that higher quality assets must trade with a lower
probability, or must be less liquid, because this is the way to e¤ectively screen

9

out seller with lower quality assets.
A related paper is “Trading Dynamics in Decentralized Markets with Adverse Selection,” by Braz Camargo and Benjamin Lester. They also study a
dynamic, decentralized market with asymmetric information and interdependent values between buyers and sellers. In the model, buyers and sellers are
randomly matched each period, and sellers have private information about the
quality of their goods. If trade occurs, then the pair exits the market; otherwise, they remain in the market and are randomly matched with new trading
partners in the following period. Since the composition of goods remaining in
the market at each point in time is endogenous, a key component of an individual’s strategy is whether to trade now or to wait for conditions to improve.
The model delivers a stark relationship between the severity of the information frictions and market liquidity, measured by the expected amount of time it
takes to a sell high-quality goods. This framework can be used to understand
how asymmetric information has contributed to the recent …nancial crisis, to
describe how such markets might clear over time on their own, and to study the
e¤ects of government intervention.
Anonymity plays an important role in making money essential. But anonymity
can also constrain choices available to the monetary authority, an aspect of
monetary policy implementation that has not been fully examined in the literature. In “Costly Recordkeeping, Settlement System and Monetary Policy,”
Pere Gomis-Porqueras and Daniel Sanchez study the implications of anonymity
for optimal policy. They assume that the government lacks the technology to
verify agents’identities and their private trades. As a result, it must rely on the
public information that is voluntarily created, at a cost, by the private sector in
order to implement monetary policy. If not all private transactions are publicly
reported, then the injections of …at money will be asymmetric. In this case,
the socially e¢ cient allocation cannot be implemented by any incentive-feasible
policy. The optimal monetary policy for an economy with a low recordkeeping
cost and a large number of public transactions has positive in‡ation and nominal
interest rates. Like the other papers in this section, this one helps us understand
better some important aspects of policy making in an uncertain world.
Similarly, in “Money and Credit: The Role of the Informal Sector,” Pere
Gomis-Porqueras, Adrian Peralta-Alva, and Chris Waller use a search model of
monetary exchange to study sellers’ decision to either be paid in cash or use
credit. Since credit trades are recorded, the government can levy taxes. Cash
avoids any record of the transaction and, hence, taxation. A seller’s choice is
really one of being anonymous or not. In the absence of distortionary taxes,
only a credit equilibrium exists, since money is costly to hold. If taxes are
distortionary, then a monetary equilibrium will exist for su¢ ciently low in‡ation
rates. Credit will be used only when in‡ation rates are high. If the preferences
of agents are heterogeneous, then money and credit can coexist, with both being
used in some transactions.
In “Information in a Monetary Search Model,” Mei Dong and Janet Hua
Jiang study the role of information transparency in a monetary model. There
are two types of buyers in the economy: one type is fully informed about the
10

price postings by each seller, and the other type is partially informed, only
knowing the aggregate distribution of price postings. The e¤ect of information transparency can be analyzed in cases. When information transparency is
low, increasing transparency results in higher real price and worsens the terms
of trade for buyers (and for sellers). With medium information transparency,
higher transparency causes real prices to decrease and the terms of trade for
buyers to improve. When the fraction of fully informed buyers is high, increasing transparency does not e¤ect the economy. Costs associated with holding
money or with ex ante investments have important implications about the effect of information transparency.
Some recent monetary economics literature studies counterfeiting, but most
the papers do not have counterfeiting occurring in equilibrium. This seems contrary to what we observe, where counterfeiting of bank notes in some countries
has recently experienced rapid increases. In “Counterfeit Quality and Veri…cation in a Monetary Exchange,”Ben Fung and Enchuan Shao examine conditions
under which counterfeiting can occur and, when it does, how policy including
anti-counterfeiting measures a¤ects it. The authors use a competitive search
environment, where sellers post o¤ers and buyers direct their search based on
posted o¤ers. When sellers are uninformed, their o¤ers are pooling and, as a
result, buyers are able to extract rents by using counterfeits. Counterfeit notes
can coexist with genuine notes. Since the interaction between sellers’veri…cation
decisions and counterfeiters’choices of counterfeit quality is explicitly modeled,
the authors can study how policies a¤ect counterfeiting.

7

Theory

There were several papers on pure monetary theory. In “A Monetary Theory
with Non-Degenerate Distributions,”Guido Menzio, Shouyong Shi and Hongfei
Sun construct a tractable directed-search model with a non-degenerate distribution of money holdings. This is useful since, obviously, in actual economies some
individuals hold more money than others. The rationale underlying a range of
policies designed for reallocating liquidity among individuals depends on the distribution of money holdings. However, much monetary theory has abstracted
from this non-degenerate distribution for reasons of tractability. Menzio et al. in
their model have a distribution of money holdings that is non-degenerate. This
distribution a¤ects individuals’ decisions indirectly through a one-dimensional
variable— the wage rate. This relationship drastically reduces the state space for
individuals’ decisions, and makes the model relatively tractable. In the equilibrium, buyers follow a stylized spending pattern over time, and the money
distribution has a persistent wealth e¤ect.
Going back to the original Kiyotaki-Wright model of commodity money, it
is well known that this framework has a large multiplicity of dynamic equilibria. In “Period Length and the Set of Dynamic Equilibria with Commodity
Money,” Ezra Ober…eld and Nicolas Trachter analyze the role that the length
of a period plays in determining the extent of this multiplicity. They adapt the

11

basic model so that they can vary period length without altering the fundamentals of the economy. The symmetric version of their model is characterized by
multiplicity of equilibrium and complicated dynamics when the period length is
strictly positive. The continuous time limit of their setup, however, has a unique
symmetric equilibrium. They show that as the time period shrinks, the sets of
possible equilibrium payo¤s, local averages of strategies played, and dynamic
paths of the economy all converge uniformly to those of the unique equilibrium
in the continuous time limit. Hence, when the relevant time period is short, all
equilibrium paths are well approximated by that of the continuous time limit.
In “Endogenous Credit Cycles,”Chao Gu and Randall Wright study the ‡uctuations in credit markets with limited commitment. Agents are free to renege
on debt obligations, but those who are (probabilitistically) caught are punished
by exclusion from future credit. This gives rise to an endogenous credit limit.
When the credit limit is binding, collateral can help mitigate the commitment
problem, but does not completely solve it. Two mechanisms for the credit are
examined, Nash bargaining and Walrasian pricing. For both mechanisms, the
model can display exotic dynamic equilibria, including deterministic or stochastic cycles, and chaotic dynamics. In some equilibria, credit conditions change
over time, even though fundamentals are deterministic and stationary. Such
changes are self-ful…lling prophecies. Also in these equilibria, credit limits may
bind in some periods but not others, illustrating how it is possible to generate credit freezes. It is also argued that pure credit models resemble monetary
models in some interesting ways, especially in the sense that beliefs play an
important role in determining equilibria.
In “Money in a Model of Prior Production and Imperfectly Directed Search,”
Adrian Masters provides an analysis of how in‡ation a¤ects behavior and welfare
when goods must be produced prior to the point of sale. This implies that sellers
have to make inventory decisions based on expected market conditions while
their potential customers decide how much cash to bring to the market based
on expected trading opportunities. Customers’have preference shocks that are
private information, and sellers in equilibrium charge everyone the same price.
If a buyer likes the good, but not su¢ ciently to pay the seller’s posted price,
they may not trade even though there are positive gains from trade. Monetary
policy can mitigate this ine¢ ciency: a departure from the Friedman rule can
improve matters. In this case, in‡ation erodes the value of money, which means
buyers become less picky and prefer to purchase today rather than wait until
tomorrow. This e¤ect of in‡ation is reminiscent of the so-called hot potato
e¤ect. This paper usefully connects several earlier analyses in one framework.
The next theory paper is motivated by empirical studies that suggest the
price elasticity of demand for a given brand is primarily determined by changes
in the number of customers purchasing that product, rather than changes in
the quantity purchased by each customer. In “In‡ation and Price Competition” Boragan Narajabad develops monetary model with directed-search and
endogenous search intensity to explore the implications of monetary policy for
price distributions, output and average productivity. The are two ine¢ ciencies:
less productive producers produce and producer prices exceed marginal cost.
12

Although a little in‡ation can increase output and improve average productivity, it raises the welfare of the lucky consumers— those who are matched with
productive producers— while lowers that of unlucky consumers— those who are
matched with unproductive producers
A related paper is “Optimal Monetary Policy: Distribution E¢ ciency vs.
Production E¢ ciency,” by Haitao Xiang. The paper studies the trade-o¤ between distribution and production e¤ects of monetary policy when there are
idiosyncratic liquidity shocks. In absence of risk-sharing arrangements, monetary policy serves to provide ex post insurance to smooth consumption. When
liquidity shocks are observable, a type-contingent money transfer can redistribute purchasing power among consumers desirably; when liquidity shocks are
unobservable, an illiquid bond policy helps. Both policies have positive distributional e¤ects, but the resulting in‡ation has a negative e¤ect on production.
The author provides a su¢ cient condition under which social welfare can be
improved by an in‡ationary monetary policy, i.e., if consumers are su¢ ciently
relative risk averse, the trade-o¤ between distributional e¢ ciency gains and
production e¢ ciency losses results in net improvement.
In “The coordination value of monetary exchange: Experimental evidence,”
Gabriele Camera and Marco Casari uncover a new behavioral foundation for why
money promotes impersonal exchange. In experiments, subjects can cooperate
by intertemporally exchanging goods with anonymous opponents they meet at
random. Inde…nite repetition can support multiple equilibria, from full defection to the e¢ cient outcome. Introducing the possibility to hold and exchange
intrinsically worthless “tickets” that resemble …at money can help equilibrium
selection. Monetary exchange facilitates coordination on cooperation and redistributes surplus from defectors to cooperators. These …ndings o¤er new insights
about cooperation in groups of individuals involved in long-term interactions
and contributes to a large literature on repeated games. Experiments such as
these provide some evidence to assess the validity of such theories. In addition,
this study contributes to an experimental literature on money. In contrast to
previous experiments, money here has neither intrinsic nor redemption value.

References
[1] Nosal, Ed and Guillaume Rocheteau (2011). Money, payments and liquidity.
Cambridge: MIT Press.
[2] Williamson, Stephen and Randall Wright (2010a). “New monetarist economics: methods,” Federal Reserve Bank of St. Louis Review 92, 265-302.
[3] Williamson, Stephen and Randall Wright (2010b). “New monetarist economics: models,” In Benjamin Friedman and Michael Woodford (eds.),
Handbook of monetary economics, second edition. Amsterdam: NorthHolland.

13

Working Paper Series
A series of research studies on regional economic issues relating to the Seventh Federal
Reserve District, and on financial and economic topics.
Risk Taking and the Quality of Informal Insurance: Gambling and Remittances in Thailand
Douglas L. Miller and Anna L. Paulson

WP-07-01

Fast Micro and Slow Macro: Can Aggregation Explain the Persistence of Inflation?
Filippo Altissimo, Benoît Mojon, and Paolo Zaffaroni

WP-07-02

Assessing a Decade of Interstate Bank Branching
Christian Johnson and Tara Rice

WP-07-03

Debit Card and Cash Usage: A Cross-Country Analysis
Gene Amromin and Sujit Chakravorti

WP-07-04

The Age of Reason: Financial Decisions Over the Lifecycle
Sumit Agarwal, John C. Driscoll, Xavier Gabaix, and David Laibson

WP-07-05

Information Acquisition in Financial Markets: a Correction
Gadi Barlevy and Pietro Veronesi

WP-07-06

Monetary Policy, Output Composition and the Great Moderation
Benoît Mojon

WP-07-07

Estate Taxation, Entrepreneurship, and Wealth
Marco Cagetti and Mariacristina De Nardi

WP-07-08

Conflict of Interest and Certification in the U.S. IPO Market
Luca Benzoni and Carola Schenone

WP-07-09

The Reaction of Consumer Spending and Debt to Tax Rebates –
Evidence from Consumer Credit Data
Sumit Agarwal, Chunlin Liu, and Nicholas S. Souleles

WP-07-10

Portfolio Choice over the Life-Cycle when the Stock and Labor Markets are Cointegrated
Luca Benzoni, Pierre Collin-Dufresne, and Robert S. Goldstein

WP-07-11

Nonparametric Analysis of Intergenerational Income Mobility
with Application to the United States
Debopam Bhattacharya and Bhashkar Mazumder

WP-07-12

How the Credit Channel Works: Differentiating the Bank Lending Channel
and the Balance Sheet Channel
Lamont K. Black and Richard J. Rosen

WP-07-13

Labor Market Transitions and Self-Employment
Ellen R. Rissman

WP-07-14

First-Time Home Buyers and Residential Investment Volatility
Jonas D.M. Fisher and Martin Gervais

WP-07-15

1

Working Paper Series (continued)
Establishments Dynamics and Matching Frictions in Classical Competitive Equilibrium
Marcelo Veracierto

WP-07-16

Technology’s Edge: The Educational Benefits of Computer-Aided Instruction
Lisa Barrow, Lisa Markman, and Cecilia Elena Rouse

WP-07-17

The Widow’s Offering: Inheritance, Family Structure, and the Charitable Gifts of Women
Leslie McGranahan

WP-07-18

Incomplete Information and the Timing to Adjust Labor: Evidence from the
Lead-Lag Relationship between Temporary Help Employment and Permanent Employment
Sainan Jin, Yukako Ono, and Qinghua Zhang

WP-07-19

A Conversation with 590 Nascent Entrepreneurs
Jeffrey R. Campbell and Mariacristina De Nardi

WP-07-20

Cyclical Dumping and US Antidumping Protection: 1980-2001
Meredith A. Crowley

WP-07-21

Health Capital and the Prenatal Environment:
The Effect of Maternal Fasting During Pregnancy
Douglas Almond and Bhashkar Mazumder

WP-07-22

The Spending and Debt Response to Minimum Wage Hikes
Daniel Aaronson, Sumit Agarwal, and Eric French

WP-07-23

The Impact of Mexican Immigrants on U.S. Wage Structure
Maude Toussaint-Comeau

WP-07-24

A Leverage-based Model of Speculative Bubbles
Gadi Barlevy

WP-08-01

Displacement, Asymmetric Information and Heterogeneous Human Capital
Luojia Hu and Christopher Taber

WP-08-02

BankCaR (Bank Capital-at-Risk): A credit risk model for US commercial bank charge-offs
Jon Frye and Eduard Pelz

WP-08-03

Bank Lending, Financing Constraints and SME Investment
Santiago Carbó-Valverde, Francisco Rodríguez-Fernández, and Gregory F. Udell

WP-08-04

Global Inflation
Matteo Ciccarelli and Benoît Mojon

WP-08-05

Scale and the Origins of Structural Change
Francisco J. Buera and Joseph P. Kaboski

WP-08-06

Inventories, Lumpy Trade, and Large Devaluations
George Alessandria, Joseph P. Kaboski, and Virgiliu Midrigan

WP-08-07

2

Working Paper Series (continued)
School Vouchers and Student Achievement: Recent Evidence, Remaining Questions
Cecilia Elena Rouse and Lisa Barrow
Does It Pay to Read Your Junk Mail? Evidence of the Effect of Advertising on
Home Equity Credit Choices
Sumit Agarwal and Brent W. Ambrose

WP-08-08

WP-08-09

The Choice between Arm’s-Length and Relationship Debt: Evidence from eLoans
Sumit Agarwal and Robert Hauswald

WP-08-10

Consumer Choice and Merchant Acceptance of Payment Media
Wilko Bolt and Sujit Chakravorti

WP-08-11

Investment Shocks and Business Cycles
Alejandro Justiniano, Giorgio E. Primiceri, and Andrea Tambalotti

WP-08-12

New Vehicle Characteristics and the Cost of the
Corporate Average Fuel Economy Standard
Thomas Klier and Joshua Linn

WP-08-13

Realized Volatility
Torben G. Andersen and Luca Benzoni

WP-08-14

Revenue Bubbles and Structural Deficits: What’s a state to do?
Richard Mattoon and Leslie McGranahan

WP-08-15

The role of lenders in the home price boom
Richard J. Rosen

WP-08-16

Bank Crises and Investor Confidence
Una Okonkwo Osili and Anna Paulson

WP-08-17

Life Expectancy and Old Age Savings
Mariacristina De Nardi, Eric French, and John Bailey Jones

WP-08-18

Remittance Behavior among New U.S. Immigrants
Katherine Meckel

WP-08-19

Birth Cohort and the Black-White Achievement Gap:
The Roles of Access and Health Soon After Birth
Kenneth Y. Chay, Jonathan Guryan, and Bhashkar Mazumder

WP-08-20

Public Investment and Budget Rules for State vs. Local Governments
Marco Bassetto

WP-08-21

Why Has Home Ownership Fallen Among the Young?
Jonas D.M. Fisher and Martin Gervais

WP-09-01

Why do the Elderly Save? The Role of Medical Expenses
Mariacristina De Nardi, Eric French, and John Bailey Jones

WP-09-02

3

Working Paper Series (continued)
Using Stock Returns to Identify Government Spending Shocks
Jonas D.M. Fisher and Ryan Peters

WP-09-03

Stochastic Volatility
Torben G. Andersen and Luca Benzoni

WP-09-04

The Effect of Disability Insurance Receipt on Labor Supply
Eric French and Jae Song

WP-09-05

CEO Overconfidence and Dividend Policy
Sanjay Deshmukh, Anand M. Goel, and Keith M. Howe

WP-09-06

Do Financial Counseling Mandates Improve Mortgage Choice and Performance?
Evidence from a Legislative Experiment
Sumit Agarwal,Gene Amromin, Itzhak Ben-David, Souphala Chomsisengphet,
and Douglas D. Evanoff

WP-09-07

Perverse Incentives at the Banks? Evidence from a Natural Experiment
Sumit Agarwal and Faye H. Wang

WP-09-08

Pay for Percentile
Gadi Barlevy and Derek Neal

WP-09-09

The Life and Times of Nicolas Dutot
François R. Velde

WP-09-10

Regulating Two-Sided Markets: An Empirical Investigation
Santiago Carbó Valverde, Sujit Chakravorti, and Francisco Rodriguez Fernandez

WP-09-11

The Case of the Undying Debt
François R. Velde

WP-09-12

Paying for Performance: The Education Impacts of a Community College Scholarship
Program for Low-income Adults
Lisa Barrow, Lashawn Richburg-Hayes, Cecilia Elena Rouse, and Thomas Brock
Establishments Dynamics, Vacancies and Unemployment: A Neoclassical Synthesis
Marcelo Veracierto

WP-09-13

WP-09-14

The Price of Gasoline and the Demand for Fuel Economy:
Evidence from Monthly New Vehicles Sales Data
Thomas Klier and Joshua Linn

WP-09-15

Estimation of a Transformation Model with Truncation,
Interval Observation and Time-Varying Covariates
Bo E. Honoré and Luojia Hu

WP-09-16

Self-Enforcing Trade Agreements: Evidence from Antidumping Policy
Chad P. Bown and Meredith A. Crowley

WP-09-17

Too much right can make a wrong: Setting the stage for the financial crisis
Richard J. Rosen

WP-09-18

4

Working Paper Series (continued)
Can Structural Small Open Economy Models Account
for the Influence of Foreign Disturbances?
Alejandro Justiniano and Bruce Preston

WP-09-19

Liquidity Constraints of the Middle Class
Jeffrey R. Campbell and Zvi Hercowitz

WP-09-20

Monetary Policy and Uncertainty in an Empirical Small Open Economy Model
Alejandro Justiniano and Bruce Preston

WP-09-21

Firm boundaries and buyer-supplier match in market transaction:
IT system procurement of U.S. credit unions
Yukako Ono and Junichi Suzuki
Health and the Savings of Insured Versus Uninsured, Working-Age Households in the U.S.
Maude Toussaint-Comeau and Jonathan Hartley

WP-09-22

WP-09-23

The Economics of “Radiator Springs:” Industry Dynamics, Sunk Costs, and
Spatial Demand Shifts
Jeffrey R. Campbell and Thomas N. Hubbard

WP-09-24

On the Relationship between Mobility, Population Growth, and
Capital Spending in the United States
Marco Bassetto and Leslie McGranahan

WP-09-25

The Impact of Rosenwald Schools on Black Achievement
Daniel Aaronson and Bhashkar Mazumder

WP-09-26

Comment on “Letting Different Views about Business Cycles Compete”
Jonas D.M. Fisher

WP-10-01

Macroeconomic Implications of Agglomeration
Morris A. Davis, Jonas D.M. Fisher and Toni M. Whited

WP-10-02

Accounting for non-annuitization
Svetlana Pashchenko

WP-10-03

Robustness and Macroeconomic Policy
Gadi Barlevy

WP-10-04

Benefits of Relationship Banking: Evidence from Consumer Credit Markets
Sumit Agarwal, Souphala Chomsisengphet, Chunlin Liu, and Nicholas S. Souleles

WP-10-05

The Effect of Sales Tax Holidays on Household Consumption Patterns
Nathan Marwell and Leslie McGranahan

WP-10-06

Gathering Insights on the Forest from the Trees: A New Metric for Financial Conditions
Scott Brave and R. Andrew Butters

WP-10-07

Identification of Models of the Labor Market
Eric French and Christopher Taber

WP-10-08

5

Working Paper Series (continued)
Public Pensions and Labor Supply Over the Life Cycle
Eric French and John Jones

WP-10-09

Explaining Asset Pricing Puzzles Associated with the 1987 Market Crash
Luca Benzoni, Pierre Collin-Dufresne, and Robert S. Goldstein

WP-10-10

Does Prenatal Sex Selection Improve Girls’ Well‐Being? Evidence from India
Luojia Hu and Analía Schlosser

WP-10-11

Mortgage Choices and Housing Speculation
Gadi Barlevy and Jonas D.M. Fisher

WP-10-12

Did Adhering to the Gold Standard Reduce the Cost of Capital?
Ron Alquist and Benjamin Chabot

WP-10-13

Introduction to the Macroeconomic Dynamics:
Special issues on money, credit, and liquidity
Ed Nosal, Christopher Waller, and Randall Wright
Summer Workshop on Money, Banking, Payments and Finance: An Overview
Ed Nosal and Randall Wright

WP-10-14

WP-10-15

6