Econ 810: Monetary Theory
Overview: The goal is to study theoretical frameworks that can help us make sense of recent 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.
Update (July 18): I recently came across this free e-book, by Robert Wright and Vincenzo Quadrini "Money and Banking"
Grading will be based on the following:
Midterm 1. Thursday, June 09, 2011
Midterm 2. Thursday, July 14, 2011
Final Exam. Tuesday, August 16, 2011
Term paper (optional). Due on August 16, 2011
If you choose not to submit a term paper, your course grade will be based on the formula MAX{0.2*MT1 + 0.3*MT2 + 0.5*FINAL, FINAL}.
If you choose to submit a term paper, for your final grade I will use it to replace your worst midterm exam.
You should start thinking of a topic soon after the first midterm. Come and see me and I'll get you started.
1. Introduction. An overview of monetary exchange. Definitions. The frictions that make money essential.
Reading 1: Introduction.
2. 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. Ed Nosal and Guillaume Rocheteau have written an excellent textbook that describes the framework along with several applications. The manuscript is due to be published in 2011, by the MIT Press. A preliminary version of the manuscript is available here. I will also make use of lecture slides based on this text prepared by Aleksander Berentsen.
Reading 1: Chapter 1 (NR text)
Lecture slides: The Basic Environment (Berentsen)
Reading 2: Chapter 2 (NR text)
Lecture slides: Pure Credit Economies (Berentsen)
Lecture slides: Incentives and Credit in a Quasilinear Environment (Andolfatto)
Reading 3: Chapter 4 (NR text)
Lecture slides: Money in Equilibrium (Berentsen)
Lecture slides: Money in a Quasilinear Environment (Andolfatto)
Reading 4: The Simple Analytics of Money and Credit in a Quasilinear Environment (Andolfatto)
Reading 5: On the Social Cost of Transparency in Monetary Economies (Andolfatto)
Lecture slides: Chicago2009 (Andolfatto)
References: Here is a list of papers that apply this general framework to various questions (c. 2008)
3. Overlapping Generations (OLG) models. This class of models was the precursor to the quasilinear models studied above. Many people express a dislike for OLG models, perhaps because people have a tendency to interpret the 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.
Reading 1: Notes on the Overlapping Generations Model (Wright)
Lecture slides: Money and Capital in the OLG Model (Andolfatto)
Blog post: Money and Inflation (Andolfatto, July 21, 2010)
Blog post: Interpreting Recent Movements in the Money Supply and Price-Level (Andolfatto, July 26, 2010)
Blog post: Global Imabalances: Good for the World? (Andolfatto, August 25, 2010)
Reading 2: Is QE2 a Savior, Inflator, or Dud? (Cochrane, June 2, 2011); see also: Quantitative Easing (Cochrane)
Reading 3: Monetary Implications of the Hayashi-Prescott Hypothesis for Japan (Andolfatto, 2003)
4. International Money Systems. Was the Euro doomed to fail?
Reading 1: Macroeconomic Theory and Policy, Chapter 8. Andolfatto (2008).
Reading 2: Exchange Rate Volatility in an Equilibrium Asset Pricing Model, Manuelli and Peck (1990). International Economic Review, 31(3): 559-574.
Reading 3: Lecture Notes ( Andolfatto)
Lecture slides: Exchange Rates (Andolfatto)
5. Topics for discussion. Some very interesting bloggers out there. Let's take a look at what some are saying. (Feel free to suggest your own topics.)
[1] Newmonetarist Economics: Understanding Unconventional Monetary Policy (Steve Williamson, 2011)
[2] Are recessions caused by an excess demand for money?
Reading 1: Do Keynesians Understand Their Own Models? (Nick Rowe, WCI)
Reading 2: Is There an Excess Demand for Base Money? (AdamP, Canucks Anonymous)
[3] The U.S. Recession of 2008-201? (Robert E. Lucas, Jr.)
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Optional chapters:
Lecture 5. Properties of Money.
Lecture 6. Monetary Policy.
Lecture 7. Money and Credit.
Lecture 8. Settlement.
Lecture 10. Liquidity and Asset Prices.
Lecture 11. Liqudity and Trading Frictions.
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BELOW IS THE OLD COURSE OUTLINE
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).
Readings:
Contracts and Money, Boyan Jovanovic and Masako Ueda (JPE, 1997).
Optional:
Contracts and Money, Boyan Jovanovic and Masako Ueda (NBER 5637, 1996).
Contracts and Money Revisited, Antoine Martin and Cyril Monnet (BEPress, 2006).
Lecture Notes.
Topic 2: Debt Contracts
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.
Readings:
Why is There Debt?, Jeff Lacker (1991).
Financial Intermediation and Delegated Monitoring, Doug Diamond (1984).
Optimal Debt Contracts, David Andolfatto (2008).
Optional:
Financial Intermediation as Delegated Monitoring: A Simple Example, Doug Diamond (1996).
Topic 3: Demandable Debt and Banking
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.
Readings:
The Role of Demandable Debt in Structuring Optimal Banking Arrangements, Calomiris and Kahn (AER, 1991).
Lecture Notes.
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.
Readings:
Lecture Notes.
Optional:
Bank Runs, Deposit Insurance, and Liquidity, Diamond and Dybvig (JPE, 1983).
Implementing Efficient Mechanisms in a Model of Financial Intermediation, Green and Lin (JET, 2003).
Diamond and Dybvig's Classic Theory of Financial Intermediation: What's Missing?, Green and Lin (FRBM QR, 2000).
Commitment and Equilibrium Bank Runs, Ennis and Keister (2007).
Topic 4: Optimal Trading Restrictions in Financial Markets
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.
Readings:
Lecture Notes.
Optional:
Demand Deposits, Trading Restrictions, and Risk Sharing, (Jacklin, 1987).
Optimal Financial Structure in Exchange Economies, (Haubrich, IER 1988).
Repeated Principal-Agent Relationships with Lending and Borrowing, (EL, 1985).
Efficient Allocations with Hidden Income and Hidden Storage, (Cole and Kocherlakota, REStud 2001).
A Theory of Inalienable Property Rights, (Andolfatto, JPE 2002).
Topic 5: Monetary Theory
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).
Readings:
A Suggestion for Oversimplifying the Theory of Money, Wallace (1990).
Whither Monetary Economics?, Wallace (2001).
Incentives and the Limits to Deflationary Policy, Andolfatto (2007).
Pairwise-Core Monetary Trade in the Lagos-Wright Model, Hu, Kennan, and Wallace (2007).
Money and Credit with Limited Commitment, Sanches, Williamson, and Wright (2007).
The Societal Benefits of Illiquid Bonds, Kocherlakota (2003).
Essential Interest-Bearing Money, Andolfatto (2007).
Topic 6: Money, Capital, and Banking
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).
Readings:
Champ and Freeman, Chapters 1, 3, 6, 7.
Taking Intermediation Seriously: A Comment, Andolfatto (2003).
Topic 7: International Monetary Systems
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?
Readings:
Champ and Freeman, Chapter 4.
Macroeconomic Theory and Policy, Chapter 8. Andolfatto (2008).
Exchange Rate Volatility in an Equilibrium Asset Pricing Model, Manuelli and Peck (1990). International Economic Review, 31(3): 559-574.
Lecture Notes. Andolfatto.