Recent Developments on Money and Finance: Exploring Links between Market Frictions, Financial Systems and Monetary Allocations

267 Pages·2006·1.96 MB·English

by  Gabriele Camera (auth.)

Studies in Economic Theory
Editors
Charalambos D.Aliprantis
Purdue University
Department ofEconomics
West Lafayette,in47907-2076
USA
Nicholas C.Yannelis
University ofIllinois
Department ofEconomics
Champaign,il61820
USA
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Utility Maximization.Choice and Preference
Gabriele Camera
Editor
Recent Developments
on Money and Finance
Exploring Links between Market Frictions,
Financial Systems and Monetary Allocations
With 28 Figures
and 5 Tables
123
Professor Gabriele Camera
Department ofEconomics
Krannert School ofManagement
Purdue University
47907-2056 West Lafayette,IN
USA
E-mail:[email protected]
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Table of Contents
Recentdevelopmentsonmoneyandfinance:anintroduction
GabrieleCamera ............................................ 1
PartI:Finance
Chapter 1.Optimalfinancialregulation
Depositinsuranceandbankregulationinamonetaryeconomy:ageneral
equilibriumexposition
JohnH.Boyd,ChunChang,andBruceD.Smith.................... 11
Amonetarymechanismforsharingcapital:DiamondandDybvigmeet
KiyotakiandWright
RicardodeO.Cavalcanti ...................................... 39
Chapter 2.Financialfragilityinsmallopeneconomies
Domesticfinancialmarketfrictions,unrestrictedinternationalcapital
flows,andcrisesinsmallopeneconomies
GaetanoAntinolfiandElisabethHuybens ......................... 61
Inflation,growthandexchangerateregimesinsmallopeneconomies
PaulaL.Hernandez-Verme..................................... 93
Chapter 3.Financialarrangementsanddynamicinefficiencies
Aggregate risk sharing and equivalentfinancial mechanismsin an
endowmenteconomyofincompleteparticipation
PamelaLabadie ............................................. 127
Asset pricingimplicationsof efficientrisk sharingin an endowment
economy
PamelaLabadie ............................................. 149
PartII:Money
Chapter 4.Thedistributionof moneyanditswelfareimplications
Distributionalaspectsofthedivisibilityofmoney.Anexample
GabrieleCamera ............................................ 163
VI TableofContents
Thedistributionofmoneyandpricesinanequilibriumwithlotteries
AleksanderBerentsen,GabrieleCamera,andChristopherWaller ...... 173
Chapter 5.Pricedispersion,inflationandthevalueofmoney
Money,pricedispersionandwelfare
BrianPetersonandShouyongShi................................ 197
Asimplesearchmodelofmoneywithheterogeneousagentsandpartial
acceptability
AndreiShevchenkoandRandallWright........................... 223
Chapter 6.Optimaltradingarrangementswith moneyandcredit
Decentralizedcreditandmonetaryexchangewithoutpublicrecordkeeping
DeanCorbaeandJosephRitter ................................. 235
Limitedparticipation,privatemoney,andcreditinaspatialmodelofmoney
StephenD.Williamson ........................................ 255
Recent developments on money and finance:
(cid:1)
an introduction
GabrieleCamera
DepartmentofEconomics,KrannertSchoolofManagement,PurdueUniversity,
WestLafayette,IN47907-2056,USA
[email protected]
This book assembles some currenttheoreticalwork on monetary theory, banking,
andfinance.Thepaperspublishedinthiscollectionspanawidevarietyofthemes,
frommonetarypolicytotheoptimaldesignoffinancialsystems,fromthestudyofthe
causesoffinancialcrisestopaymentssystemdesign.Iamconvincedtheywillserve
as a usefulreferenceto all researchersinterested in the study of financialsystems
andmonetaryeconomies.
Thepapersarenaturallydividedintotwoparts,oneofwhichfocusesonfinance,
andtheotheronmoney.Precisely,thefirstpartisorganizedintothreechaptersdealing
withoptimalfinancialregulation,financialfragilityandcrises,andoptimalfinancial
arrangements.Thesecondpartiscomposedofthreemorechaptersdealingwiththe
welfare implicationsof unequaldistributionsof moneyholdings,price dispersion,
the value of money in heterogeneous-agentseconomies, and optimal trading and
paymentarrangementsinmonetaryeconomies.
TothefirstpartbelongthecontributionsofAntinolfiandHuybens,Boyd,Chang
andSmith,Cavalcanti,Hernandez-Verme,andLabadie.Perhapsthecentralelement
ofcommonalityofthesecontributionsistheemphasisonhowinformationalfrictions
impingeontheoperationoffinancialsystems,andtradingarrangements.Suchfric-
tionsareintroducedintheenvironmentbyexploiting—inseveraldifferentways—the
notionofspatial/informationalseparationintroducedbyTownsend(1980).Mostpa-
persinthisgroupembedthesenotionsofseparationintheoverlappinggenerations
frameworkof Samuelson(1958),one of the workhorsesof monetarytheory.Cav-
alcantiis the onlypaperin thisgroupthat departsfromthis modelingchoice,and
insteadintroducesfrictionsusingarandom-matchingframeworkinthetraditionof
KiyotakiandWright(1989).
Thefirstchapterincorporatesworksthatdealwithtopicsrelatedtotheoptimality
offinancialmechanisms,andbankingregulationinparticular.Theopeningpiece,by
(cid:1)IwanttothankBarbaraFess,ofSpringer-Verlag,forexcellenteditorialhelp.Allthearticles,
excepttwo,werepublishedinthespecialissueofEconomicTheory24(4),2004,727-732,
whichcollectedpaperspresentedattheconference“RecentDevelopmentsinMoneyand
Finance”heldatPurdueUniversityinMay2003.Theconferencewasorganizedjointlyby
GabrieleCameraandthelateBruceD.Smith,anditwassponsoredbyPurdueUniversity’s
DepartmentofEconomics,andtheCentralBankInstituteoftheFederalReserveBankof
Cleveland.
2 G.Camera
Boyd,ChangandSmith,fillsagapintheliteratureontheoptimaldesignofdeposit
insuranceandbankregulation,inageneralequilibriumcontext.Theauthorspresent
an environmentwhere banks arise endogenously due to a problem of costly state
verification. There is also a moral hazard problem between banks and borrowers,
andsincethereisscopeforgovernment-supplieddepositinsurance,thisgivesriseto
amoralhazardproblembetweenbanksandthegovernment.Tocreateanexplicitrole
forbothmoney,andbankregulationinthemodel,areserverequirementisimposedon
banks.Theauthorsconsiderseveraldifferentmethodstofinancedepositinsurance:
insurancepremiumcollections,taxes,andseignorage.Theanalysisshowsthatthese
methodsinteractincomplexwaysandthat,ingeneral,tooheavyarelianceononetool
maycauseanadverseeconomicimpact.Aninterestingnormativeimplicationofthe
analysis,inparticular,isthatmonetizationofbanksbailouts’costsisnotnecessarily
inefficient. Regarding the positive dimension of the analysis, the paper highlights
thesignificanceofconductinganalysesofdepositinsuranceinageneralequilibrium
framework.Thestudyshowshow,ingeneralequilibrium,therelationshipbetween
deposit insurance financing and economic activity is complex, and often general
equilibriumeffectsleadtocounter-intuitiveimplications.
The contribution of Cavalcanti also focuses on optimal bank regulation. His
studyexplainswhybank’sprovisionofinsidemoneyshouldbecoordinatedwiththe
intermediationofcapital,aresultthatcallsintoquestionFriedman’s(1959)recom-
mendationthatmoneyandcreditbeseparated.Thisintuitionisdevelopedinamodel
characterizedbythesharingofstorablegoods,asinDiamondandDybvig(1983),
and the creation of inside money,as in recentextensionsof the random-matching
model of Kiyotaki and Wright (1989). In the model, financial intermediaries, or
banks,are agentswhose informationalhistoryis commonknowledge;society can
keep—andcostlesslyaccess—apublicrecordoftheiractions.Theremainingagents,
called‘non-banks,’areanonymousandsometimeshaveidlecapital.Banks’infor-
mationaladvantagesallowthemtobetterallocatecapitalthancannonbankers,for
threemainreasons.Theseinformationaladvantagesgivebanksanincentivetomake
transferstononbankers,toavoiddefection-inducedpunishments,andallowbanksto
produceforotherbankerswithouthavingtousemoney(sotheircapitaluseismore
efficient).Banksissue (butdo notoverissue) money,whichincreasesthe turnover
ofcapital.Hence,bankscanbebothconservativeissuersofinsidemoney,butalso
trustworthyreceiversofidlecapital.
Thesecondchaptercomprisestwopapers,byAntinolfiandHuybens,andHer-
nandez,whicharealsoconcernedwithfinancialregulation.Unlikethepriorchapter,
however,themainfocushereisfinancialfragilityinsmallopeneconomies.These
areeconomiesthatareopentoworldtradeandcapitalflows,butaresmallenough
to be price takers on world markets. In particular, this means that their economic
policiesandbehaviordonotaffectworldprices,interestrates,andincomes.
AntinolfiandHuybenssetupamodelthathelpsusbetterunderstandthepossi-
ble causesofinternationalfinancialcrises. Theyadoptan overlappinggenerations
framework to model a small open economy and present an example in which an
increaseintheworldinterestratecanbeassociatedwithaprecipitousdeclineineco-
Recentdevelopmentsonmoneyandfinance:anintroduction 3
nomicactivity.Thepaperhighlightshowtheinteractionofdomesticinformational
frictions,perfectcapitalmobility,andforeigninterestratescancombinetoprovoke
a sudden depreciation of the exchange rate and a prolonged decline in output. In
particular,theauthorsdescribeconditionsunderwhichtwodifferentequilibriaexist.
Onehasahighlevelofoutputandaminorcostly-state-verificationproblem,andthe
otherequilibriumhasahigherlevelofoutputandaseverecostly-state-verification
problem.Inaddition,theauthorsshowhowtheirmodelcansuccessfullysimulatea
crisispaththatisqualitativelyconsistentwithoccurrencessuchastheMexicanfinan-
cialcrisisin1994.Animportantlessonemergingfromthisworkisthatevenasmall
changeinexternalfactorscangeneratea“crisis”path,whenthisinitialshockhitsa
smallopenmonetaryeconomy,iftheeconomyfeaturesacombinationofdomestic
informationalfrictionswithinternationalcapitalflows.
Thenextpaper,byHernandez-Verme,also focuseson thestudyofsmallopen
economieswithinthecontextofanoverlappinggenerationsmodel.UnlikeAntinolfi
andHuybens,however,hermainconcernistherelativemeritsofdifferentmethods
forachievingpricestability.Todososhemergestheoverlappinggenerationsmodel
withaspatialmodelofTownsendtocomparethemeritsofalternativeexchangerate
regimes—namely,fixed and flexible. This analysis is carried out within a context
wherefinancialintermediariesperformarealallocativefunction,therearemultiple
reserverequirements,andtheeconomyissubjecttocreditmarketfrictions.Shefinds
thereisscopeforendogenousvolatility,independentoftheexchangerateregimein
place.Anotherkeyfindingisthatunderfloatingexchangerates,apositivetrade-off
between domestic inflation and outputcan be exploitedunder credit rationingbut
only if inflation is small. In fact, there exists an inflation threshold beyond which
domesticoutputsuffers.
Thethirdchapter,whichconcludesthefirstpartofthebook,presentstwocon-
tributions of Labadie, both of which focus on dynamic inefficiencies and optimal
financialarrangements.Precisely,thefirstpiececontributestotheliteratureonsto-
chastic life-cycle models. The central theme is the study of the dynamic ineffi-
cienciesthatariseinastochasticpureexchangemonetaryoverlappinggenerations
economy,whererisksharingopportunitiesarelimited.Inparticular,shestudiesthe
meritofdifferentfinancialmechanismsthatcanprovideintergenerationalinsurance.
In additionto fiat money,these mechanismsincludeequivalentgovernment-based
approaches such as risk-free bonds, state-contingent taxes, social security, or in-
come insurance. Labadie considers two categories of Pareto optimal allocations,
‘conditional’ and ‘equal-treatment.’She finds that governmentinvolvementis not
necessarytoachieveconditionallyParetooptimalallocations,i.e.allocationswhere
agentshavestate-dependentmarginalratesofsubstitution.Aself-financingtransfer
system is sufficient. However, state-contingentgovernmenttaxation is required to
achieveequal-treatmentParetooptimality,i.e.allocationswhereagentshavestate-
independentmarginalratesofsubstitution.
Thesecondpieceisanaturalextensionofthefirst,andconsidersimplicationsfor
assetpricesinanoverlappinggenerationseconomy.Here,theauthorexamineshow
afinancialinstitution,whichcanbeinterpretedasaclearinghouse,caneliminatethe
4 G.Camera
dynamicinefficiencygeneratedbyastochasticdistributionofincomeacrossagents,
atapointintime.Theobjectiveistounderstandhowtherepresentativehousehold’s
ability to insure againstendowmentrisk is affectedby the methodofoperationof
theclearinghouse.Specifically,Labadieconsiderstwoprototypicalwaystoinsure
againstsuchrisk,whicharedirectlyrelatedtothetwodifferentconceptsofPareto
optimalityseen earlier,i.e.,equaltreatmentandconditionalPareto optimality.For
eachtreatment,thepriceofriskismeasuredbyavariablereportingtheratioofthe
standarddeviationoftheintertemporalmarginalrateofsubstitution,toitsconditional
mean.Inthiscontext,themainresultisthatconditionsexistsuchthatthedistribution
ofwealthacrossagentsisirrelevantforthemarketpriceofriskunderequaltreatment
transferscheme,whereasitnotirrelevantundertheconditionaltransferscheme.
Thesecondpartofthisbookassemblespapersbelongingtoanareaofresearch
in macroeconomics,which is mainly focused on studyingthe efficiency of mone-
tary allocations that can be achieved via decentralized and uncoordinated private
decisions. It includes the papers by Berentsen, Camera and Waller, Camera, Cor-
bae and Ritter, Peterson andShi, Shevchenkoand Wright,and Williamson. These
articlesarebroadlyconcernedwiththeefficiencyofthedecentralizedmonetaryso-
lution in economies characterized by equilibrium heterogeneity. The themes con-
sidered are the equilibrium distribution of prices and monetary balances, the link
between price dispersion and the process of money creation, the endogenous ac-
ceptabilityofmoney,the interactionbetweenmoneyandcredit,andpaymentsys-
tems design.
The dominantelementof commonalityof this second group of papers is their
modelingmethodology,whichisbasedonthesearch-theoreticapproachtomonetary
economicsdevelopedbyKiyotakiandWright(1989).Thisisanequilibriummodel
ofsearchandmatchinginthetraditionof,forexample,LucasandPrescott(1974),
Hellwig(1976),Diamond(1982),Mortensen(1982),orPissarides(1990).1Thecen-
tralconcernofthismethodologyistheprovisionofanexplicitconnectionbetween
theenvironmentalconstraints—spatialandinformational,inparticular—thetrading
frictionsassumedin theenvironment,andthe possibleallocations.Theseenviron-
mentalconstraintsaremadeexplicitbyassumingpairwisematchingandanonymous
trading.Thisapproachisappealingtosomemonetaryeconomistsforthefollowing
reasons.BymovingawayfromtheWalrasianparadigm—andtowardsaframework
where trade is fragmented and subject to search frictions—money’s medium-of-
exchange role is made precise and its value determined in equilibrium, avoiding
the imposition of ad-hoc constraints or intrinsic features of money. The paper by
Williamson, which is based on these premises, does not exploit the Kiyotaki and
Wrightmodel,butinsteadproposesanentirelynovel—andcarefullyconstructed—
economicenvironmentwithspatialseparation.
ThissecondpartisopenedbyachapterthatpullstogethercontributionsbyCam-
era,andBerentsen,CameraandWaller.Thesetwopapersarecomplementarystudies
oftheefficiencyofthedecentralizedmonetarysolutionineconomiescharacterized
1Hellwig(1976)appearstobethefirstpaperthatstudiestheuseofamediumofexchange
inaneconomywithmanyagentswhomeetpairwiseandatrandomtimes.