Recent Developments on Money and Finance: Exploring Links between Market Frictions, Financial Systems and Monetary Allocations (Studies in Economic Theory)

268 Pages·2005·1.97 MB·English

by  Gabriele Camera (Editor)

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
Titles in the Series
M.A.Khanand N.C.Yannelis(Eds.) N.Schofield
Equilibrium Theory Mathematical Methods in Economics
in Infinite Dimensional Spaces and Social Choice
C.D.Aliprantis,K.C.Border C.D.Aliprantis,K.J.Arrow,P.Hammond,
and W.A.J.Luxemburg(Eds.) F.Kubler,H.-M.Wuand N.C.Yannelis(Eds.)
Positive Operators,Riesz Spaces, Assets,Beliefs,and Equilibria
and Economics in Economic Dynamics
D.G.Saari D.Glycopantis andN.C.Yannelis(Eds.)
Geometry ofVoting Differential Information Economies
C.D.Aliprantisand K.C.Border A.Citanna,J.Donaldson,H.M.Polemarchakis,
Infinite Dimensional Analysis P.Siconolfiand S.E.Spear(Eds.)
Essays in Dynamic
J.-P.Aubin General Equilibrium Theory
Dynamic Economic Theory
M.Kaneko
M.Kurz(Ed.) Game Theory and Mutual Misunderstanding
Endogenous Economic Fluctuations
S.Basov
J.-F.Laslier Multidimensional Screening
Tournament Solutions and Majority Voting
V.Pasetta
A.Alkan,C.D.Aliprantisand N.C.Yannelis Modeling Foundations ofEconomic Property
(Eds.) Rights Theory
Theory and Applications
J.C.Moore
Mathematical Methods
for Economic Theory 1
J.C.Moore
Mathematical Methods
for Economic Theory 2
M.Majumdar,T.Mitraand K.Nishimura
Optimization and Chaos
K.K.Sieberg
Criminal Dilemmas
M.Florenzanoand C.Le Van
Finite Dimensional Convexity
and Optimization
K.Vind
Independence,Additivity,Uncertainty
T.Casonand C.Noussair(Eds.)
Advances in Experimental Markets
F.Aleskerovand B.Monjardet
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]
Cataloging-in-Publication Data
Library ofCongress Control Number:2005931709
ISBN-10 3-540-27803-6 Springer Berlin Heidelberg New York
ISBN-13 978-3-540-27803-0 Springer Berlin Heidelberg New York
This work is subject to copyright.All rights are reserved,whether the whole or part ofthe material is con-
cerned,specifically the rights oftranslation,reprinting,reuse ofillustrations,recitation,broadcasting,repro-
duction on microfilm or in any other way,and storage in data banks.Duplication ofthis publication or parts
thereofis permitted only under the provisions ofthe German Copyright Law ofSeptember 9,1965,in its
current version,and permission for use must always be obtained from Springer-Verlag.Violations are liable
for prosecution under the German Copyright Law.
Springer is a part ofSpringer Science+Business Media
springeronline.com
© Springer-Verlag Berlin Heidelberg 2006
Printed in Germany
The use ofgeneral descriptive names,registered names,trademarks,etc.in this publication does not imply,
even in the absence ofa specific statement,that such names are exempt from the relevant protective laws and
regulations and therefore free for general use.
Cover design:Erich Kirchner
Production:Helmut Petri
Printing:Strauss Offsetdruck
SPIN 11410249 Printed on acid-free paper – 42/3153 – 5 4 3 2 1 0
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