Finance and Economics Discussion Series (FEDS)
November 2007
Imperfect Monitoring and the Discounting of Inside Money
Abstract:
One of the fundamental questions concerning inside money is whether its issuers should be regulated and how. This paper evaluates the efficiency of one prevalent regulatory recommendation -- a requirement that private issuers redeem inside money on demand at par -- in a random-matching model of money where the issuers of inside money are only imperfectly monitored. I find that for sufficiently imperfect monitoring, a par redemption requirement leads to lower social welfare than if private money were redeemed at a discount. A central message of the paper is that if inside money and outside money are not perfect substitutes for one another, as is the case if there is sufficiently imperfect monitoring, a par redemption requirement may not be socially optimal because such a requirement effectively binds them to circulate as if they are. Such an outcome is a version of Gresham's law that bad money drives out good money.
Full Paper (Screen Reader Version)Keywords: Inside and outside money, electronic money, imperfect monitoring, Gresham's law
PDF: Full Paper
Disclaimer: The economic research that is linked from this page represents the views of the authors and does not indicate concurrence either by other members of the Board's staff or by the Board of Governors. The economic research and their conclusions are often preliminary and are circulated to stimulate discussion and critical comment. The Board values having a staff that conducts research on a wide range of economic topics and that explores a diverse array of perspectives on those topics. The resulting conversations in academia, the economic policy community, and the broader public are important to sharpening our collective thinking.