Summer 2013

This is a course on the theory of exchange media. Exchange media are objects that facilitate exchange, in particular, intertemporal exchange (financial markets). Money is a medium of exchange because it permits trades that might not otherwise take place. A similar role is played by assets that are used extensively as collateral to support credit arrangements.

Banking refers to those activities related to managing the payments system. Private banks create money out of less liquid assets. The same is true of central banks. The short-term lending arrangements characteristic of the repo market (shadow banking sector) can also be viewed in this light.

Exchange media play no meaningful role in neoclassical economic theory, which assumes (among other things) that people can be trusted to keep their promises and, moreover, that they are always truthful. A lack of commitment (trust) and asymmetric information (potentially misreporting private information) make financial markets much more interesting than neoclassical theory assumes. Financial markets would operate at much lower volume without exchange media. Does the expanded volume of financial market activity induced by the production of exchange media also leave the financial system vulnerable to "financial crisis" events? And, if so, what types of intervention are desirable?

The 3 exams and the term paper each count for 25% of your final grade. If it is to your benefit, I will drop your worst exam and give your term paper a 50% weight.

Getting started on your term paper: It's never too soon to start thinking about topics. One way to do this is to think about questions that you find interesting and/or puzzling. An easy way to do this is to read the newspaper and popular economic blog sites. Look around in the literature and see what has been done in these areas. Identify the issues or questions that you think might be worthy of further investigation. Meet with me to discuss your ideas. Settle on a question. This last point cannot be overemphasized: You should be able to explain to an audience what question you wish to answer and why you believe the question to be important. I would like to see you apply the tools developed in class to answer your question. No page restrictions--use as many pages as you need to answer the question in a competent manner.

Course textbooks: The main textbook is Modeling Monetary Economies, 3rd edition. Authors: Bruce Champ, Scott Freeman and Joseph Haslag. This is a beautiful textbook that uses the OLG model as the framework of analysis. I will also draw on materials fromMonetary Theory and Policy, by Carl Walsh. Advanced students may also want to consult Money, Payments, and Liquidity, by Ed Nosal and Guillaume Rocheteau. There is also a free e-book by Robert Wright and Vincenzo Quadrini that might be of some interest: Money and Banking.For the history and free-banking buff, I recommend Money, Bank Credit, and Economic Cycles, by Jesus Huerta de Soto.

Course Content

INTRODUCTION
Money is a object that circulates widely as a medium of exchange. Monetary exchange is sometimes said to be needed to overcome a "lack of coincidence in wants" that is necessary for bilateral exchange to take place. I show that the lack of coincidence in wants is neither necessary nor sufficient to rationalize monetary exchange. Limited commitment is necessary to rationalize exchange media. The theory suggests that there is an economic equivalence between money and collateral. (Note: a possible term paper topic would be to explain under what circumstances money dominates collateralized debt, and vice-versa.)

THE BASIC OLG MODEL
The OLG model was developed independently by Maurice Allais in 1947 (see Maulinvaud) and Paul Samuelson in 1958. The setup is ideally suited to examining gift-giving economies and money as a record-keeping device. The first reference to the latter idea appears to be Ostroy 1973.

The (basic) OLG structure shares with the Wicksell structure a complete absence of bilateral gains to trade. In fact, the main difference between the two is the time horizon (infinite in the former, and finite in the latter). Related to this is the assumption that commitment is lacking entirely in the OLG framework, but is only limited (to one person) in the Wicksell model. The infinite time horizon is necessary to explain the use of fiat money (since fiat money cannot be valued in the final period, at least, assuming voluntary trade). But it is not so clear that we should be obsessed with fiat money; in fact, most monetary instruments in history have been at least partially backed (see, e.g., Champ 2007 below). There is also the question of why fiat money is necessary when other assets (potential monetary instruments) exist.

As in any economic model, there is the question of what policy can accomplish. It is well known that if we give the government (in our models) enough policy instruments and a good motive, then most economic problems disappear. Most of the time, I adopt the fiction of a benevolent government with the realistic assumption of limited instruments. A restriction that I commonly employ is that of voluntary trade. That is, there are limits to what society can force individuals to do. Among other things, this typically rules out the use of lump-sum taxes (although taxes relating to the volume of trade are permitted). The assumption of sequential rationality rules out commitment on the part of agents. Sometimes I also restrict attention to linear mechanisms (like competitive equilibrium).

MONEY AND CAPITAL IN THE OLD MODELIn this section, I introduce an asset in the form of reproducible capital (an alternative would have been to introduce a fixed asset, like a Lucas tree). Because physical capital is (among other things) a store of value, it can potentially serve as an exchange medium. In the OLG model, the laissez-faire competitive equilibrium potentially exhibits a "dynamic inefficiency." As usual, this inefficiency, which leads to an overaccumulation of capital, can be corrected by an appropriate fiscal policy. One fiscal policy entails the introduction of interest-bearing government debt (money), with interest financed by lump-sum tax revenue.

The dynamic inefficiency that is possible in an OLG model also emergences in more standard macro models with debt constraints (e.g., see Woodford 1986 below). A debt constraint is a restriction that arises from limited commitment. For example, an agent may wish to borrow using future wages as collateral, but the physical (or legal) properties associated with human capital may make it difficult to do so.

In the OLG model, a Lucas tree that can be used as private money drives fiat money (zero-interest money) out of circulation. The same would be true of interest-bearing government debt. Fiat money cannot coexist with another asset with identical risk-characteristics that dominates in rate of return.

NOMINAL DEBT AND PRICE-LEVEL SHOCKSMost debt is nominal--it is not indexed to the price-level. When inflation is low and stable (easily forecastable), nominal debt is of little concern. But a large and persistent price-level shock (modeled here as a monetary policy shock, but could be the consequence of any type of shock) may lead to a "debt-overhang" phenomenon that depresses economic activity far into the future. If debt-renegotiation is costly, monetary policy in the form of a price-level target may help smooth the impact of such a shock.

MONEY AND BANKING A distinguishing characteristic of banks (relative to other intermediaries) is that their liabilities are demandable (demand deposit liabilities). Specifically, bank liabilities are convertible into cash on demand and at par (resembles an American put option).

Overview: The goal is to study theoretical frameworks that can help us interpret and otherwise make sense of recent (and historical) financial market developments and to see what these theories suggest in the way of appropriate interventions in (and following) a financial market crisis. We will begin by reviewing the foundations of monetary exchange and the role of banks as suppliers of liquidity. At some point we will discuss the role of central banks, the emergence of the "shadow banking" sector (repo market), the special properties of exchange media, including collateral objects, and the role such objects play in a financial crisis.

Grading will be based on the following:

Midterm 1. Thursday, June 14, 2012
Midterm 2. Thursday, July 05, 2012
Midterm 3. Tuesday, July 24, 2012
Term paper. Due one week following the last day of classes The 3 exams and the term paper will each count for 25% of your final grade. Note: there will be no final exam for this class.

Getting started on your term paper: It's never too soon to start thinking about topics. One way to do this is to think about questions that you find interesting and/or puzzling. An easy way to do this is to read the newspaper and popular economic blog sites. Look around in the literature and see what has been done in these areas. Identify the issues or questions that you think might be worthy of further investigation. Meet with me to discuss your ideas. Settle on a question. This last point cannot be overemphasized: You should be able to explain to an audience what question you wish to answer and why you believe the question to be important. I would like to see you apply the tools developed in class to answer your question. No page restrictions--use as many pages as you need to answer the question in a competent manner.

Course textbooks: The main textbook is Modeling Monetary Economies, 3rd edition. Authors: Bruce Champ, Scott Freeman and Joseph Haslag. This is a beautiful textbook that uses the OLG model as the framework of analysis. Advanced students may also want to consult Money, Payments, and Liquidity, by Ed Nosal and Guillaume Rocheteau. There is also a free e-book by Robert Wright and Vincenzo Quadrini that might be of some interest: Money and Banking.For the history and free-banking buff, I recommend Money, Bank Credit, and Economic Cycles, by Jesus Huerta de Soto.

Course Outline

1. Introduction.Money (def): an object that circulates widely as a form of payment. What are the properties of an environment that make monetary exchange more efficient? A lack of double coincidence of wants (LCDW) is necessary, but not sufficient (e.g., an Arrow-Debreu market can easily handle a LDCW). When people give up a good or service now, they want something in return. In a world with perfect commitment, a promise to deliver a good or service in the future (to either the seller, or someone else) can serve as a form of payment. Such promises, however, need not circulate. When commitment is limited, the same sort of promises (possibly limited in level and scope) can be used as a form of payment, if the promises are supported by the threat of a credible punishment (e.g., trigger strategies that ostracize people who do not keep their promises). The limited commitment friction alone, however, still does not imply a demand for a circulating exchange medium (although it does give rise to a demand for exchange media in the form of collateral assets). Since debt arrangements under limited commitment require record-keeping (generally, a set of individual trading histories), the absence of record-keeping (the existence of anonymous agents) induces a demand for circulating exchange media. Sellers can now ask buyers to "show them the money" (as opposed to, show me your credit history). In this sense, money is a form of memory.

2. Overlapping Generations (OLG) models. People have a tendency to interpret the OLG environment too literally. Personally, I like OLG models, mainly because they are simple, and because money is valued for precisely the same reason it is valued in any good monetary model. Moreover, one should keep in mind that Woodford (JET 1986) demonstrates that debt-constrained economies possess dynamics that are similar to OLG models. Debt-constraints (limited commitment) form the foundation of monetary exchange.

5. Quasilinear models. Ricardo Lagos and Randy Wright came up with a simple, yet brilliant, idea for simplifying the analysis of monetary economies. Their idea now serves as the basic framework for a growing body of literature.

Overview: This will be more a course of selected topics, rather than a course on monetary theory per se. Of course, the topics will relate to monetary theory, even if the link is not immediately apparent. There is still much work to be done in the area; so PhD students in particular should find much fruitful ground for potential thesis chapters.

Grading: There will be one midterm exam (20%); one final exam (30%); and a term paper (50%).

Topic 1: Nominal Contracts

Why are nominal contracts frequently not indexed to the price-level? I have only ever seen one paper that comes close to providing a logically consistent answer to this question (whether the argument is persuasive, however, is a different matter).

The striking feature of a debt contract is that payments are fixed over a wide range of circumstances, although occasionally, as in default, less than full payment is made. Explaining why standard debt contracts are so prevalent poses a challenge for conventional economic theory. In an Arrow-Debreu world, for example, state-contingent payments are the norm. Moreover, in many conventional settings, a Miller-Modigliani theorem holds so that debt is not essential. Monetary theorists should concern themselves with the theory of debt as virtually all monetary instruments take this form.

We will begin our investigation by exploring a simple (static) class of models. The basic idea seems to have been formalized first by Robert Townsend (1979). I recommend reading at least the introduction of his paper.

Virtually all monetary instruments embed within them an American put option. This is a debt instrument that allows the holder to redeem the debt object for some other object (the object of redemption) at a prespecified price and on demand. This is the way modern bank money works: your bank demand deposit contract allows you to redeem your bank money (make a withdrawal) whenever you want for government cash and (frequently) at par. In the U.S. Free-Banking Era (1836-63), chartered banks issued paper notes that were redeemable for specie (gold and silver coin). Governments frequently issued money redeemable in gold (gold standard systems). Currency boards that peg the local currency to a foreign currency typically allow for redemption on demand. Even money in the form of specie can be thought of as embedding a put option (the holder is free to melt down the coin for its metal value).

What explains this property of some forms of debt? Calomiris and Kahn (AER, 1991) offer one explanation that relies on the idea of demandable debt as a mechanism to discipline the debt-issuer from absconding with deposited funds. In their model, depositors can exercise a right to liquidate their deposits for no apparent reason (i.e., if they receive information that leads them to grow overly suspicious of the bank's probable future behavior). This is not quite the same as withdrawing money from a bank say, for transactions purposes--but it does identify one possible role that the threat of mass redemption (i.e., a bank-run) might play in disciplining the banking system. Overall, this is a very well-written paper, but the formal model is not as elegant as it might be--maybe you can do better.

Another potential explanation for institutions that issue demandable debt instruments is to be found in the classic Diamond and Dybvig (1983) model. This model has been used extensively to explain how a banking system might give rise to self-fulfilling "bank run" equilibria. However, much of the recent literature demonstrates that the original Diamond-Dybvig model permits bank-run equilibria only under some ad hoc assumptions about contract structure.

This idea goes against every libertarian bone in my body: Can people be made better off by restricting their trading activity? Evidently, the answer is yes; at least, under some circumstances. The basic idea goes back at least to Hart (1975). Jacklin (1987) made the same point in the context of the Diamond-Dybvig model.

O.K., enough of that stuff (for the time-being, anyway). It's now time to start talking about money. Money can be defined in general terms as an object that circulates as a medium of exchange. You may have noticed that none of the papers cited above discusses such an object. At this point, I want to tackle the question of "fiat money"--which is defined as an intrinsically useless token object (think of government-issued cash). Fiat money is sometimes referred to as "outside money;" which is to be distinguished from "inside money" (financial claims issued by the private sector that circulate as a means of payment); see Lagos (2006) "Inside and Outside Money."

Some people question whether there is even such a thing as fiat money; see "The Myths of Fiat Money" by Dror Goldberg (I am sympathetic to his argument). But setting this issue aside, let us imagine that fiat money exists. Then the great theoretical challenge is to explain how an intrinsically useless token may nevertheless come to have value in exchange. We are not going to find the answer in Debreu's Theory of Value (incidentally, the Arrow-Debreu market structure can handle an absence of double-coincidence of wants very easily). The key frictions that give rise to a circulating medium are presently identified to be: [1] limited commitment; and [2] limited record-keeping (rendering at least a subset of agents "anonymous"). The record-keeping function of money goes back at least to Ostroy (1973); see "The Informational Efficiency of Monetary Exchange." Townsend (1989) elaborates on this idea in "Currency and Credit in a Private Information Economy." The point is nicely summarized by Kocherlakota (1998) in "The Technological Role of Fiat Money."

I am not going to spend any time talking about "Search Models of Money." This may seem odd to you, given the preponderance of monetary models based on the search framework. Here, I can refer to the work of Randy Wright--the leading developer of this strand of the literature. As it turns out, money has value in a search environment precisely because that environment naturally gives rise to the important limited commitment and anonymity frictions highlighted above; and not because of the search frictions per se (although, the search frictions do give rise to other interesting interactions).

The asset side of a bank's balance sheet looks similar to many other companies (investments in capital projects and cash reserves). The distinguishing characteristic appears to be in the structure of their liabilities, a good part of which consists of liabilities convertible into cash on demand (demand deposit liabilities).

What determines the equilibrium nominal exchange rate between two fiat currencies? Should countries allow their exchange rate to float, or should they consider pegging their currency to some other currency? Should some countries consider abandoning their own currency altogether in favor of another? Or should countries consider joining a currency union?