Randall Wright
University of Pennsylvania
August 11, 2003
Abstract
This paper develops a new theory of money and banking based on an
old story about money and banking. The story is that bankers originally
accepted deposits for safe keeping ; then their liabilities began to circulate
as means of payment (bank notes or checks). We develop models where
money is a medium of exchange, but subject to theft, where theft may be
exogenous or endogenous. We analyze how the equilibrium circulation of
cash and demand deposits varies with the cost of banking and the outside
money supply. We study cases with 100% reserves and with fractional
reserves.
¤ We thank Ken Burdett, Ed Nosal, Peter Rupert, Joseph Haubrich, Warren Weber, Fran-
cois Velde, Steve Quinn and Larry Neal for suggestions or comments. We thank the NSF and
the Federal Reserve Bank of Cleveland for ¯nancial support. The usual disclaimer applies.
1
The theory of banking relates primarily to the operation of commer-
cial banking. More especially it is chie°y concerned with the activ-
ities of banks as holders of deposit accounts against which cheques
are drawn for the payment of goods and services. In Anglo-Saxon
countries, and in other countries where economic life is highly devel-
oped, these cheques constitute the major part of circulating medium.
EB (1954, vol.3, p.49).
1 Introduction
This paper develops a new theory of money and banking based on an old story
about money and banking. This story is so well known that it is described nicely
in standard reference books like the Encyclopedia Britannica: \the direct ances-
tors of moderns banks were, however, neither the merchants nor the scrivenors
but the goldsmiths. At ¯rst the goldsmiths accepted deposits merely for safe
keeping; but early in the 17th century their deposit receipts were circulating in
place of money and so became the ¯rst English bank notes." (EB 1954, vol.3,
p.41). \The cheque came in at an early date, the ¯rst known to the Institute of
More specialized sources echo this view. As Quinn (1997, p.411-12) puts it,
a network of bankers. ... Some were little more than pawn-brokers while others
1 To go into more detail: \To secure safety, owners of money began to deposit it with the
London goldsmiths. Against these sums the depositor would receive a note, which originally
was nothing more than a receipt, and entitled the depositor to withdraw his cash on presen-
tation. Two developments quickly followed, which were the foundation of `issue' and `deposit'
banking, respectively. Firstly, these notes became payable to bearer, and so were transformed
from a receipt to a bank-note. Secondly, inasmuch as the cash in question was deposited for
a ¯xed period, the goldsmith rapidly found that it was safe to make loans out of his cash
resources, provided such loans were repaid within the ¯xed period.
\The ¯rst result was that in place of charging a fee for their services in guarding their
client's gold, they were able to allow him interest. Secondly, business grew to such a pitch
that it soon became clear that a goldsmith could always have a certain proportion of his cash
out on loan, regardless of the dates at which his notes fell due. It equally became safe for
him to make his notes payable at any time, for so long as his credit remained good, he could
calculate on the law of averages the exact amount of gold he needed to retain to meet the
daily claims of his note-holders and depositors." (EB 1941, vol.3, p.68). See Neal (1994) for
a discussion of various other ¯nancial institutions and intermediaries at the time, including
scrivenors, merchant banks, country banks, etc.
2
were full service bankers. The story of their system, however, builds on the ¯-
the 17th century, notes, orders, and bills (collectively called demandable debt)
acted as media of exchange that spared the costs of moving, protecting and
assaying specie." Similarly, Joslin (1954, p.168) writes \the crucial innovations
in English banking history seem to have been mainly the work of the goldsmith
bankers in the middle decades of the seventeenth century. They accepted de-
posits both on current and time accounts from merchants and landowners; they
made loans and discounted bills; above all they learnt to issue promissory notes
and made their deposits transferrable by `drawn note' or cheque; so credit might
be created either by note issue or by the creation of deposits, against which only
A story, even a very good story, is not a theory. What kind of a model could
we use to study banks as institutions whose liabilities may substitute for money
for a medium of exchange in the ¯rst place. One such framework is provided
would need to relax the severe assumptions made in most of these models,
process, to even contemplate something like a bank. To this end we adopt certain
aspects of the framework in Lagos and Wright (2002), where agents interact in
points in time. At the same time, there would have to be some friction over and
above those in the typical search-based model to generate a role for a second
2 According to Quinn (2002), e.g., \To avoid coin for local payments, Renaissance mon-
eychangers had earlier developed deposit banking in Italy, so two merchants could go to a
banker and transfer funds from one account to another." It seems however that these earlier
deposit banks did not really provide checking services: transferring funds from one account to
another \generally required the presence at the bank of both payer and payee." (Kohn 1999b).
3
means of payment, in addition to cash.
The historical literature gives us guidance here by telling us that money was
actually less than the ideal means of payment. Among other things, coins were
in short supply, were hard to transport, got clipped or worn, and could be lost or
stolen. With the expansion of commerce the need for a better means of payment
and bills of exchanges that reduced the need for actual cash (Kohn 1999a,b,c).
The idea presented here is exactly this: cash (outside money) is imperfect and
hence there arises a role for an alternative means of payment, which will be
¯lled by the demandable debt of banks (inside money). The sense in which
cash is imperfect in our model is that it is subject to theft while bank deposits
are relatively safe. More generally our focus is on banks' provision of payment
services, which today is important as ever, given recent moves towards hopefully
safer or more convenient services, including debit cards, electronic money, etc.
We hope this will provide not only a fresh perspective on banking, but will
also help to extend the search models to include some interesting institutions
safety. This seems consistent with the historical view of the services provided
by banks or more generally by bills of exchange which were not payable to the
includes Cavalcanti and Wallace (1999a,b), Cavalcanti et al. (2000), and Williamson (1999).
Models that study the interaction among alternative media of exchange, inaddition to the
above, include Matsuyama at al. (1993), Burdett et al. (2001), and Peterson (2002).
4
and from this one could get a theory of bank notes, we emphasize safety as
the key advantage of bank deposits in the present model and hence think of it
The rest of the paper is organized as follows. Section 2 presents the basic
assumptions of the model. Section 3 analyzes the simplest case, where theft
is exogenous, money and goods are indivisible, and we impose 100% reserves.
monetary economics into which the current paper ¯ts; the interested reader is
2 Basic Assumptions
tially, a fraction M 2 [0; 1] of the population are each endowed with one unit
4 It may be useful to de¯ne some terms at this point. A bill of exchange is an order
in writing, signed by the person giving it (the drawer), requiring the person to whom it is
addressed (the drawee) to pay on demand or at some ¯xed time a given sum of money to
a named person (the payee), or to the bearer. A cheque is a particular, form of bill, where
a bank is the drawee and it must be payable on demand. Quinn (2002) also refers to bills
as \similar to a modern traveler's check." It is clear that safety was and is a key feature
of checks. For one thing, the payee needs to endorse the check, so no one else can cash it
without committing forgery; other features include the option to \stop" a check or \cross" it
(make it payable only on presentation by a banker). Indeed, the word \check" or \cheque"
originally signi¯ed the counterfoil or indent of an exchequer bill on which was registered the
details of the principal part to reduce the risk of alteration or forgery; the check or counterfoil
parts remained in the hands of the banker, the portion given to the customer being termed a
\drawn note" or \draft."
We also note here that, while declining, checks are still the most common means of payment
in the US. According to the Philadelphia Inquirer (Feb.14, 2003, p.A1), \There has been a
20% drop in personal and commercial check-writing since the mid 1990s, as credit cards,
check cards, debit cards, and online banking services have reduced the need to pay with
written checks. [But] Checks are still king. The latest annual ¯gures from the Federal Reserve
show 30 billion electronic transactions and 40 billion checks processed in the United States."
Moreover, \While credit cards reduce the number of checks that need to be written in retail
stores, the credit-card balance still has to be paid every month. And, at least for now, that is
usually done by mail { with a paper check."
5
of money, which is an object that is consumed or produced by anyone but has
money here is most easily interpretted as ¯at, although it would not be espe-
cially hard to redo things in terms of commodity money, say following Kiyotaki
and Wright [1989] or Velde et al. [1999]). To begin, in this section we follow the
early literature in the area and assume that goods as well as money are indivisi-
ble and that agents can store at most one unit of money at a time. While there
have been many recent advances in monetary theory that do away with these
restrictive assumptions, there is no doubt that even such simplistic models yield
insights into monetary economics, and they have some advantages in terms of
Agents want money not for its own sake but to use as a medium of exchange
As mentioned above, these goods are indivisible here, but this is relaxed below.
As they are nonstaorable, the goods are produced for immediate trade and
population can produce a specialized good that you want. A meeting where
someone can produce what you want is called a single coincidence meeting;
for simplicity, there are no double coincidence meetings, so we can ignore pure
barter, but it would not be hard to relax this. Consuming a specialized good
that you want conveys utility u. Producing a specialized good for someone else
it can be stolen. We assume for simplicity that goods cannot be stolen (you
cannot force anyone to produce). Also, because each individual can store at
6
most one unit of money, only individuals without money steal { so it is truly
money that is the root of all evil here. In each meeting with an agent holding
cash in the exchange process you attempt to steal it with probability ¸, which
is exogenous for now, but this will be endogenized below. Given that you try
to steal it, with probability ° you are successful. Theft has a cost z < u. We
or less costly than honest trade, and could be more or less likely to succeed. Of
easier and more likely to pay o®, while if c · z and x ¸ ° then honest work
dominates. If z < c and x > °, for instance, there is a trade o® { crime is less
types of money. The ¯rst type is outside money, the cash that can be stolen.
We assume that the M units of money with which agents are initially endowed
is this unsafe outside money. Each one can, however, potentially deposit his
we said above, one way to think of these assets is that they are like traveller's
checks: they are signed by the agent when he gives up his cash, and must be
signed a second time when exchanged for goods; if not endorsed in this way,
the bank is under no obligation to redeem the check for cash. Even if agents
could potentially steal checks, they would be of no value as long as we rule out
Following Lagos and Wright (2002), each period before the random trading
process begins, agents are all together in a centralized location. In this ¯rst
subperiod, say in the morning, agents cannot produce the specialized goods that
will be traded in the random matching market that convenes that afternoon.
7
However, they can produce and consume a so-called general good, which for
simplicity conveys linear utility (this can be relaxed without di±culty for our
producing Q units conveys disutility ¡Q. General goods are perfectly divisible,
but they are produced only in the morning and are nonstorable, so that they
cannot be used to trade for special goods in the random matching market that
agents cannot trade bilateral promises to exchange specialized goods for general
goods to be delivered next morning. Any interest or fees at the bank will be
Later, agents (but not banks) meet in the afternoon market's anonymous
bilateral matching market. Anonymity implies that agents will never surrender
2001). Hence in this market we must have quid pro quo. In principle, this can
cash because banks credibly commit to redeeming the former as long as it has
are enforced, say by legal authorities, but it is not hard to imagine reputation
playing such a role. In any case, as there may be both inside and outside money
circulating, we let M0 be the total amount of cash and M 1 the total amount of
3 Exogenous Theft
In this section we study the model where stealing is exogenous: if agent i with
money meets agent j without money, j will simply try to rob i with some ¯xed
8
probability ¸.5 When j tries to steal i's money, with probability ° he succeeds,
while with probability 1 ¡ ° he fails and must leave empty handed. With proba-
bility 1 ¡¸, j does not try to rob i but rather acts as a \legitimate businessman"
{ which means that, if he can produce a specialized good that i likes, they can
trade. We ¯rst study the case where the only asset is money, which yields a
simple extension of the most basic search model of monetary exchange (e.g.
Kiyotaki and Wright 1993). After studying this case, we introduce banking.
3.1 Money
with 1 unit of money and V 0 the value function of an agent with no money. We
where r is the rate of time preference. For example, the ¯rst equation says that
the °ow value to holding money rV 1 is the sum of two terms: the ¯rst is the
probability of meeting someone without money who does not try to rob you
and can produce a good you like, (1 ¡ M )(1 ¡ ¸)x, times the gain from trade
equilibria that are ignored from now on). The incentive condition for agents to
the people they meet with money and the rest never do, but it is slightly easier to assume
everyone does so with some probability.
9
exogenous for now: with probability ¸ agents cannot help themselves and must
V 1 ¸ 0, since we allow agents to drop out of the economy and live in autarky with
equilibrium here simply requires that when agents participate and produce in
hold.
Figure 1 depicts C M and CA in (x; c) space using the properties in the following
M ¸°z 0
Lemma 1 (a) x = 0 ) CM = r+¸° , CA = ¡1. (b) CM > 0, C 0A > 0. (c)
[r+ (1¡M ) ¸°]z
C M = C A i® (x; c) = (x¤ ; z), where x¤ = (1¡M ) (1¡¸)(u¡ z) .
(1 ¡ ¸)x[(1 ¡ M )u + M c] + ¸M z
Vm ¡ V0 = :
r + (1 ¡ ¸)x + ¸
10
Figure 1:
bigger.6 Also notice that either of the two constraints c · CM and c · C A may
either the pure resource cost z or the opportunity cost of thieves not producing;
11
3.2 Banking
We now introduce institutions where agents can make deposits into accounts
on which they can write checks. Checks are safe by assumption: thieves cannot
steal them, or, if they could, checks are redeemable unless signed.7 In this sec-
tion we assume 100% reserve requirements: a bank simply keeps your money
in its vault and earns revenue by charging a fee Á for this service, paid each
itive and banks incur constant cost a to manage each depositor's account. As
an agent with money decides each morning to put his money in the bank (or,
with cash, and V d the value function of an agent with money in his checking
account, exclusive of the fee a. Hence, for an agent with 1 dollar in the morning,
V 1 = maxfV m ; V d ¡ ag.
Although checks will be perfectly safe, it facilitates the discussion for now
to proceed more generally and let ° m and ° d be the probabilities that one can
successfully steal from someone with money and from someone with a checking
1
Vj = [(1 ¡ M)(1 ¡ ¸)x(u + V0 ) + (1 ¡ M)¸°j V0 + ³V1]
1+ r
where ³ = 1 ¡ (1 ¡ M)(1 ¡ ¸)x ¡ (1 ¡ M)¸°j . The ¯rst term is the expected payo® from
a trade, the second is the expected payo® from a theft, and the third is the expected payo®
from leaving the market with an asset worth 1 dollar that can be used as cash or deposited
next period. Multiplying by 1 + r and subtracting Vj from both sides yields the equation in
the text.
12
Notice the last term disappears if V 1 = V j ; e.g., if there is no banking this
In principle we could allow a thief to steal from a money holder or depositor with
set ° m = ° and ° d = 0.
clear that
µ = 1 ) V d ¡ a ¸ V m ; µ = 0 ) V d ¡ a · V m ; and µ 2 (0; 1) ) V d ¡ a = V m :
Equilibrium satis¯es this condition, plus the incentive condition for money to
de¯ne
where a^ = (1 + r)a. Figure 2 show the situation in (x; c) space for two cases,
13
z < C4 and z > C 4, where
^a
C4 = ;
(1 ¡ M )¸°
that the Figures are drawn correctly by describing the relevant properties of Cj ,
and relating them to CM and CA from the case with no banks; again the easy
proof is omitted.
Figure 2:
i® (x; c) = (¹
x ; C4 ), C2 = C3 i® (x; c) = (~
x ; C4 ), and C 1 = C A i® (x; c) = (~ ~
x ; C),
where
^ (r + ¸°) ¡ M (1 ¡ M )¸2 ° 2 z
a
x¹ =
(1 ¡ M )(1 ¡ ¸)[(1 ¡ M )¸°u ¡ ^a]
^a[r + (1 ¡ M )¸°]
x~ = :
(1 ¡ M )(1 ¡ ¸)[(1 ¡ M )¸°u ¡ ^a]
14
We can now prove the following:
However, now we also need to check Vm ¸ Vd ¡ a so that not going to the bank
(1 + r)(V d ¡ V m ) = (1 ¡ M )¸°(V 1 ¡ V 0 ):
Inserting V d ¡ V m = a and
(1 ¡ ¸)x[(1 ¡ M )u + M c] + M 0 ¸°z
V1 ¡ V0 = ;
r + (1 ¡ ¸)x + (1 ¡ M + M 0)¸°
We need to check M0 2 (0; M ), which is equivalent to µ 2 (0; 1). There are two
15
Figure 3:
binding constraint is x ¸ x~ . ¥
Based on the above results, Figure 3 shows the situation when x¹ and x~ are
in (0; 1).9 In the case z > C4 , shown in the left panel, we always have a unique
© for any number in (0; 1). In the case z < C 4 , shown in the right panel, we
may have a unique equilibrium but we may also have multiple equilibria with
µ = 1 and µ = ©, or with all three equilibria. Recall that without banks the
9 The assumption ^
a < (1 ¡ M)¸°u mentioned above guarantees ~
x > 0, and it is easy to see
that ¹x > 0 i® M(1 ¡ M)¸2° 2z < (r + ¸°)^
a. We also have
(1 ¡ M)2 ¸(1 ¡ ¸)°u + M(1 ¡ M)¸2° 2z
¹
x < 1 i® ^
a<¹
a=
r + ¸° + (1 ¡ ¸)(1 ¡ M)
(1 ¡ M) 2¸(1 ¡ ¸)°u
~
x < 1 i® ^
a<~
a= :
r + (1 ¡ M)(1 ¡ ¸ + ¸°)
We do not need x
¹ and x
~ in (0; 1), but if x
~ > 1, e.g., equilibria with µ > 0 disappear.
16
monetary equilibrium exists i® c · minfCM ; C Ag. Hence, if it exists without
banks monetary equilibrium still exists with banks, and it may or may not
entail µ > 0. However, there are parameters such that there are no monetary
equilibria without banks while there are with banks. In these equilibria we must
that for some parameters, and in particular for relatively large x and c, money
Figure 4 shows how the set of equilibria evolves as ^a falls. For very large ^a
a^ two things happen: in the region where there was a monetary equilibrium
without banks, the nature of the equilibrium changes as some or all of the
agents start using checks; and in some regions where there were no monetary
the region where µ = 0 shrinks. As ^a falls still further we switch from the case
z < C4 to the case z > C4 ; thus, for relatively small a^ equilibrium must be
that checks will completely drive currency from circulation. Note however that
this is not especially robust: en the next section when we endogenize theft we
will see that banking can never completely drive out money.
An very similar picture of the equilibrium set would emerge if we let M fall,
since reducing M raises the demand for checking services just like reducing ^a.
One reason for this result is the fact that less cash implies a higher demand for
17
Figure 4:
the top row has z > C4 and the bottom z < C 4 , and in both rows the left panel
has M smaller than the right panel. Lower M makes µ > 0 more likely, but the
reason now is not that lower M implies more criminals; rather, lower M simply
makes money more valuable, which makes you more willing to pay to keep it
safe.10
We close this section with a few details. First, there are other slices of
10 In any case, the results are consistent with the historical evidence that people are more
likely to use demandable debt as means of payment when money is in short supply (a classic
reference is Ashton [1945] while a more recent study is Cuadras-Morato and Ros¶es [1998]).
18
Figure 5:
parameter space that one could use to illustrate the results; for example, the
following ¯gure shows the equilibrium set in (z; a) space for progressively larger
values of c, which will be useful for comparison with one of the generalizations
the concurrent circulation of cash and checks. Obviously, the reason cash and
checks may be both used even though they have di®erent rates of return { i.e.,
19
one has a fee Á = a > 0 and the other does not { is the fact one is safer. In other
words, the model does not display rate of return dominance. Still, we think it
captures something simple but still interesting and historically relevant about
banking.
Figure 6:
20
4 Endogenous Theft
generality, but beyond that the model with ¸ exogenous does have some features
that one may wish to avoid for certain issues (e.g. when M goes down the crime
with ¸ endogenous is that checks can never completely drive currency from
circulation: if no one uses cash, then no one will choose crime, but if there is
no crime then cash is perfectly safe and no one would pay for checks. Hence
it is more likely to have concurrent circulation. So, while many points can be
made with ¸ exogenous, we also want to work things out with ¸ endogenous.
Paralleling the previous section, we start with the case where money is the only
4.1 Money
thief at the beginning of each period, given beliefs about the choices of others.
rV t = M °(V 1 ¡ V t ¡ z) + (1 ¡ M °)(V0 ¡ Vt );
21
The equilibrium conditions are
¸ = 1 ) V t ¸ Vp , ¸ = 0 ) V t · Vp , and ¸ 2 (0; 1) ) Vt = Vp ;
that we can never have an equilibrium with ¸ = 1, since we cannot have agents
¸ = 1 ) rV 1 = (1 ¡ M )°(V 0 ¡ V 1 ) · ¡(1 ¡ M )¹
° c < 0;
(1 ¡ M )xu
c0 =
r + (1 ¡ M )x
(x ¡ °)(1 ¡ M )xu + °(r + x)z
c1 =
x[r + (1 ¡ M )x + M °]
[r + M x + (1 ¡ M )°] °z
c2 = :
(r + °)x
22
Figure 7:
Inserting the value functions and simplifying, the former reduces to c · c1 and
¸ = ¸ ¤ , where
23
when c is low or x is high. Given a monetary equilibrium exists, it is more
likely that ¸ = 0 when c is low or x is high, since both of these make honest
c is bigger. When x ¤ < ° (e.g., when z is small, as shown in the ¯gure), there
is a region of (x; c) space with x < ° where an equilibrium with ¸ 2 (0; 1) exists
region where equilibrium with ¸ 2 (0; 1) and ¸ = 0 coexist. In the case where
¸ 2 (0; 1) exists uniquely it has the natural comparative static properties, such
but this condition is actually never binding: for any x, as ¸ increases we hit
¸ 2 (0; 1) exists uniquely, as c increases we get more thieves, but long before
the entire population resorts to crime people stop producing in exchange for
cash and the monetary equilibrium breaks down. In any case, as in the simpler
model with ¸ ¯xed, again the possibility of crime hinders the use of money, and
4.2 Banking
24
and V 1 = maxfV m ; Vd ¡ ag. Again V 0 = maxfVp ; V t g, where
rV p = M x(V 1 ¡ V p ¡ c) + (1 ¡ M x)(V 0 ¡ V p )
¸ = 1 ) V t ¸ Vp ; ¸ = 0 ) V t · Vp ; and ¸ 2 (0; 1) ) Vt = Vp ;
µ = 1 ) V d ¡ a ¸ V m ; µ = 0 ) V d ¡ a · V m ; and µ 2 (0; 1) ) V d ¡ a = V m :
In this section, since things are more complicated, we analyze possible equi-
libria one at a time. In principle, there are nine qualitatively di®erent types of
equilibria, since each endogenous variable ¸ and µ can be 0, 1, or © 2 (0; 1), but
25
Figure 8:
where
A0 = °x2 [r + (1 ¡ M )x + M °]
The function c11 is shown in Figure 8 for both positive and negative values of x,
even thoug x < 1 makes no economic sense. As the solution to a quadratic, c11
below, and c¡ r+ M ° + ¡
11 ! ¡1 as x ! ¡ 1¡M from above. Also, (c 11 ; c 11 ) ! (¡1; ¡1)
¡
as x ! 0 from below, and (c+ 11 ; c 11 ) ! (1; 1) as x ! 0 from above. Also,
³ ´
¡
(c+
11 ; c 11 ) !
a
^
° (1¡M )
; u as x ! §1, where the ¯gure is drawn assuming
a^ < u°(1 ¡ M ). Finally, notice in the ¯gure that there is a region of (0; 1)
where there is no solution; this is true for big ^a, but for smaller a^ this region
disappears and there are two solutions for all x 2 (0; 1).
26
Figure 9:
This is seen more clearly in Figure 9, which shows c11 as well as c0 and c1
for x 2 [0; 1] and c 2 [0; u]. In the left panel, drawn for large a^, c11 does not
exist in the neighborhood of x = ° (for still bigger ^a, c11 would not even appear
in the ¯gure). As ^a shrinks, c11 exists for more values of x, and at some point
further, c11 exists for all x > 0, as in the right panel. One can also show the
then c1 < c¡
11 ; if c 11 exists in the neighborhood of x = ° then c 11 = c 1 at
= (c¡
[z; c1 ), and c 2 +
= (c¡
11 ; c 11 ); or x < °, c 2 (c 1 ; z], and c 2
+
11 ; c 11 ).
Proof: In this case the conditions for ¸ 2 (0; 1) are exactly the same as in the
= (c¡
which is equivalent to c 2 11 ; c 11 ). ¥
+
27
The region where equilibrium with µ = 0 and ¸ 2 (0; 1) exists is the shaded
¸ 2 (0; 1) from the model with no banks, we also have to be sure now that people
= (c¡
are happy carrying cash instead of checks, which reduces to c 2 +
11; c 11 ). For
We now consider equilibria with µ 2 (0; 1) and ¸ 2 (0; 1). To begin, we have
Lemma 6 If there exists an equilibrium with ¸ 2 (0; 1) and µ 2 (0; 1), then
p
¡B § B 2 ¡ 4AC x[^a ¡ (1 ¡ M )¸°c]
¸= and µ = 1 ¡
2A(1 ¡ M ) °[^a ¡ (1 ¡ M )¸°z]
V t . Solving Bellman's equations and inserting the value functions into these
for ¸. ¥
28
k
c6 =
[2(r + x) ¡ M x]°
p
k+¡ k2 ¡ 4[r + (1 ¡ M )x]°xu^a
c7 =
2[r + (1 ¡ M )x]°
¡k + 2(r + x)°z
c8 =
M x°
xu^a ¡ kz + (r + x)°z 2
c9 =
M °xz
(x ¡ °)k + 2(r + x)°2 z
c10 =
[2(r + x) ¡ M (x ¡ °)]x°
properties of the cj 's and relate them to c0 , c1 and c11 , continuing to assume
a
^
Lemma 7 (a) x = 0 ) c3 = c4 = c5 = c8 = c9 = c10 = 1 and c6 = ¡ 2r < 0.
(b) c03 < 0, c04 < 0, c05 < 0, c06 > 0, c08 < 0, c09 < 0. (c) c7 ¸ 0 exists i®
³ ´
x ¸ x7 2 (0; 1); if c7 exists then c¡0 +0 + ¡
7 < 0, c 7 > 0 and (c 7 ; c 7 ) !
a
^
° (1¡M ) ; u
¡
as x ! 1; c7 2 (c3 ; c0 ) and (c+
7 ; c7 ) ! (c 0 ; 0) as a
^ ! 0. (d) c10 = c1 at
(x; c) = (°; z); c6, c8 and c10 all cross at c = z, and c7 , c9 and c11 all cross
The cj are shown in (x; c) space below for various values of ^a progressively
equilibrium with µ 2 (0; 1) and ¸ 2 (0; 1). The shaded area is the region
where equilibrium with µ 2 (0; 1) and ¸ 2 (0; 1) exist, as proved in the next
Proposition.
conditions are satis¯ed: (i) c > c¸ = maxfc3 ; minfc4 ; c5 gg; (ii) c > maxfc8 ; c9 g
29
Figure 10:
= (c¡
c2 + ¡ +
11 ; c 11 ), or (iii-b) x < ° and either c > c 10 or c 2 (c 11 ; c 11 ).
¸ 2 (0; 1) exists. We now check the following conditions: when does a solution
to this quadratic in ¸ exist; when is that solution in (0; 1); when is the implied
30
p
¡[(1 ¡ M )°xu + (x ¡ °)(1 + r)a] ¡ 4(r + x)(1 + r)a°xua
c · = c03
M °x
It is easy to check that c3 > c003 > c03 , and so ¸ > 0 exists i® c ¸ c3 .
forward analysis shows this holds i® c > minfc4 ; c5 g. Hence we conclude that
equations gives us
M0 x(W ¡ c)
1¡µ = = .
M °(W ¡ z)
For the last part, µ > 0 holds i® (x ¡ °)W < xc ¡ °z. When x > °, µ > 0
xc¡ °z
is therefore equivalent to W < x¡°
, = (c¡
which holds i® c > c10 and c 2 +
11 ; c 11 ).
xc¡°z
Moreover, notice that when x > °, c < z implies W < x¡ °
< c, and therefore,
W > xc¡°z
x¡°
, which is equivalent to c > c10 or c¡ +
11 < c < c11 . This completes the
proof. ¥
31
The following ¯gure puts together everything we have learned in this section
and shows the equilibrium set for decreasing values of ^a. For very big ^a the
equilibrium set is just like the model with no banks. As ^a decreases, equilibria
0 < ¸ < 1), and we also expand the set of parameters for which there exists a
monetary equilibrium. That is, for relatively high values of x and c there cannot
thieves and cash would be too risky; once banks are introduced, for intermediate
a^ values, agents will deposit their money into safe checking accounts. The fall
in a^ actually has two e®ects on the value of money: the direct e®ect is that it
makes it cheaper for agents to keep their money safe; the indirect e®ect is that
The next Figure shows what happens as M increases. Again, the lower is the
supply of M the more likely it is that we observe equilibrium with µ > 0. Clearly
equilibrium. Thus, even if banking is almost, free some cash will still circulate
because as more and more people opt for checking the number of criminals goes
down and cash actually becomes very safe. The more general point is that as
the cost of cash substitutes falls there can be general equilibrium e®ects that
make the demand for these substitutes fall relative to the demand for money,
and the net e®ect may be that cash is driven entirely out of circulation.
32
Figure 11:
5 Prices
So far we have been dealing with indivisible goods and money in the decentral-
ized market, which means that every trade is a one-for-one swap. Here we follow
the approach in Shi (1995) and Trejos and Wright (1995) and endogenize prices
by making the specialized goods divisible. We do this here only in the case
33
Figure 12:
As before we start with money and later add banking. Without banks, we have
where u(q) is the utility from consuming and c(q) the disutility from producing
While any bargaining solution could be used, for simplicity we assume the
34
agent with money gets to make a take-it-or-leave it o®er.12 Given c(q) = q, the
and so
rV 0 = M ¸°(V 1 ¡ V 0 ¡ z):
is the same as the threshold CM de¯ned in the model with indivisible goods,
except that u(q) replaces u. We also need to check the participation condition
is the same as the threshold C A, except that u(q) replaces u. This can be reduced
and there always exists a unique monetary equilibrium q 2 (0; q¹), as well as
equilibrium does not exist. The reason is as follows: even if you believe others
give q = 0 for a dollar, you would still be wiling to produce some q^ > 0 in
exchange for money since this keeps you from stealing, which has a cost if z > 0
and no bene¯t given q = 0; hence 0 is not a ¯xed point. This e®ect would go
away if ¸ were endogenous, however. In any case the equilibrium price level is
p = 1=q. As long as z is not too big, we have @q=@¸ < 0 and @q=@° < 0 { i.e.
more crime means money will be less valuable and prices will be higher.
12 When ¸ is endogenous, take-it-or-leave o®ers by buyers would be a bad assumption be-
cause it implies sellers gets no gains from trade, and so crime becomes a dominant strategy.
35
With banks, we have
rV d = (1 ¡ M )(1 ¡ ¸)x[u(q) + V 0 ¡ V 1 ] + V1 ¡ Vm
rV 0 = M (1 ¡ µ)¸°(V 1 ¡ V 0 ¡ z);
µ = 1 ) V d ¸ Vm ; µ = 0 ) V d · V m ; and µ 2 (0; 1) ) Vd = V m :
This latter condition holds i® q · C 1 (q), where C 1 is the same as in the model
with indivisible goods except that u(q) replaces u, which can be reduced to
as saying that for µ = 0 we need the cost of banking ^a to exceed the beni¯t,
which is the probability of meeting someone who steals your money (1 ¡ M )¸°
replaces u,
(1 ¡ M )(1 ¡ ¸)xu(q) ¡ ^a
C2 = :
r + (1 ¡ M )(1 ¡ ¸)x
For small values of ^a there are two solutions to q = C 2 (q) and for large ^a there
are none. Hence, we require ^a below some threshold, say ^a2 , in order for there
36
need to check V m · V d ¡ a. This holds i® q ¸ C3 (q), where C 3 is the same as
in the model with indivisible goods except that u(q) replaces u. The condition
equilibrium value of q when µ = 1, this condition says that we need the cost
someone who steals your money (1 ¡ M )¸° times the value of money q1 . This
to q = C 2 (q) exceeds C4 while the other does not, in which case there is only
one equilibrium q. Also note that the conditions for µ in the two equilibria
requires C4 · q1 , but the equilibrium values q0 and q1 are generally not the
same.
can now solve for M0 and check M 0 2 (0; M ). Recall that with q ¯xed there
divisible and we use take-it-or-leave-it o®ers the latter possibility will violate the
C3 (C4 ) · C4 · C 1 (C4 ):
37
6 Fractional Reserves
We now allow banks to lend money. Since we saw above how the model can be
case where ¸ and q are exogenous. If someone without money borrows from
the bank, he can choose to hold the loan as cash or make a deposit. There is
reserve ratio ® set by the government. While there is a cost a for each unit of
deposit service, there is no cost for the loan service but this is easily relaxed.
Banks charge a fee of Á for deposit services, but since they can lend money it
will lend out as much as possible, therefore the reserve constraint is binding. As
above, M0 is the measure of agents with cash and M 1 the measure of agents with
cash or deposits. Now L is the measure of agents with loans, and D the measure
D + M0 = M1 .
rV d = (1 ¡ ¸)(1 ¡ M1 )x(u + V0 ¡ V1 ) + V1 ¡ Vd
above. We now also have the following equilibrium conditions: ¯rst, the interest
rate that clears the loan market is ½ ¸ V1 ¡ V 0 with equality if L > 0; and
38
second, zero pro¯t by banks requires a = (1 ¡ ®)r½ + Á, since the left hand side
is per period cost per dollar deposited and the right hand side is per period
revenue (this reduces to the zero pro¯t condition used above, a = Á, when
D + M0 = M1 , we have M1 ¡ M = (1 ¡ ®)(M 1 ¡ M 0 ) or
M ¡ ®M 1
M0 = :
1¡®
after inserting the zero pro¯t condition. Hence, any ½ between V 1 ¡ V0 and
that no one go to the bank from the model with ® = 1. Algebra implies that
[r + (1 ¡ ¸)x + ¸°]^
a (1 ¡ M )u ¸°z
C1 = ¡ ¡
[(1 ¡ ®)r(1 + r) + (1 ¡ M )¸°]M (1 ¡ ¸)x M (1 ¡ ¸)x
Notice that this reduces to the expression for C 1 in the model with no loans
when ® = 1.
Now suppose that µ > 0, so that M 1 = M =[1 ¡ µ(1 ¡ ®)]. The way to
39
can make (1 ¡ ®)µM loans, of which a fraction µ is deposited, which means
banks can make (1 ¡ ®) 2 µ2 M more loans, etc. The total money supply is
is always a demand for these loans because ½ is determined to clear the loan
possibly even negative; as in footnote 1, \in place of charging a fee for their
services in guarding their client's gold, they were able to allow him interest."
Notice however, that when Á < 0 checks strictly dominate cash { they are safer
and bear interest { and so must drive cash from circulation (µ = 1).
implies
M
Inserting Á = a ¡ (1 ¡ ®)r½ and, becuase we have µ = 1, M 0 = 0 and M 1 = ® ,
(1 ¡ ¸)x[(1 ¡ M®
)u + M®
c] ¡ ^a
½= :
r[®(1 + r) ¡ r] + (1 ¡ ¸)x
Inserting ½ into the zero pro¯t condition now gives the equilibrium value of
Á, and we can insert these into the above conditoin for V m · V d ¡ Á to see that
it holds i®
40
Notice this reduces to the expression for C3 used above in the special case when
(1 ¡ ¸)(1 ¡ M 1 )xu ¡ ^a
c· = C2 :
¡r(1 + r)(1 ¡ ®) + r + (1 ¡ ¸)(1 ¡ M 1 )x
we now get
½ ¾
¸(1 ¡ M1 )° (1 + r)Á ¡ (1 ¡ ¸)x [(1 ¡ M 1 )u + M 1 c] ¡ ¸°M 0 z
Á= ;
1+r r + (1 ¡ ¸)x + ¸°M 0
which is the same the condition for the case µ = 1 except with strict equality.
these to two equations in ½ and M 1 ; one can interpret these as a deposit supply
function, say M1 = MS (½), which comes from comparing Vd and V m , and a loan
f (M1 ) = Am M 12 + Bm M 1 + C m = 0;
where
41
¡¸2 ° 2 M z ¡ ®¸ 2 °2 z + ¸°^a
Am = ¸2 ° 2 z
Bm = ¡¸2 ° 2 M z ¡ ¸ 2 °2 z + ¸°^a
Cm = ¸ 2 ° 2 M z ¡ ¸°M ^a
a
^
We can see M1 = M is a solution, and the other solution is M 1 = 1 ¡ ¸°z .
p 2
¡B m § B ¡4A C
m m
In general we need B 2m ¡ 4Am Cm ¸ 0 and m
2Am 2 [M; 1).
0 = A ½ ½ 2 + B½ ½ + C ½
From the montonicity of the money supply function, we know that in equi-
interior solution.
7 Conclusion
We have analyzed some models of money and banking based on explicit frictions
in the exchange process. Although simple, we think these models capture some-
42
thing interesting and historically accurate about banking, and they or at least
to have models in which both money and banking arise in a natural and endoge-
nous way. Some possible extensions include allowing aggregate uncertainty and
theory extensively since Diamond and Dibvyg (see the Gorton and Winton sur-
vey). Also, since modern banks actually perform a wide varierty of functions, it
may be interesting to try to study these in the context of the model (e.g. del-
The goal here was to provide a ¯rst pass at a natural and fairly simpler class
of models where money and banking arise endogenously and in accord with the
historical record.
43
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283-307.
Larry Neal (1994) \The Finance of Business during the Industrial Revolu-
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Britain since 1700, vol. 1, 1700-1860, 3rd ed. Cambridge: Cambridge Univer-
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45