Econ 810: Money and Banking

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?

Grading will be based on the following:

Midterm 1. Thursday, June 06, 2013
Midterm 2. Tuesday, July 09, 2013
Midterm 3. Thursday, August 01, 2013
Term paper. Synopsis due July 4. Paper is due on August 14.

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.)

Lecture slides: An introduction to some basic ideas


Video: Feynman lecture on methodology, c. 1964?

Readings:
John Stuart Mill: A remedy for the one-sidedness of the human mind, Kimball 2013
Private money in our past, present, and future, Champ 2007
Evil is the root of all money, Andolfatto 2012
Fiat money in theory and in Somalia, Andolfatto 2011

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).

Lecture slides: The basic OLG model
Lecture slides: Commodity money
Lecture slides: The gold standard
Lecture slides: Inflation

Readings:
Modeling monetary economies, Chapter 1 and 3
The technological role of fiat money, Kocherlakota 1998
Why gold and bitcoin make lousy money, Andolfatto 2013

Assignment 1

MONEY AND CAPITAL IN THE OLD MODEL
In 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.

Lecture slides: Money and capital in an OLG model

Readings:
Modeling monetary economies, Chapters 3 and 6

Advanced Readings (optional)
Stationary Sunspot Equilibria in a Finance Constrained Economy (Woodford, Journal of Economic Theory, 1986).
Public Debt as Private Liquidity (Woodford, American Economic Review, 1990)

NOMINAL DEBT AND PRICE-LEVEL SHOCKS
Most 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.

Lecture slides: Money, output, and the nominal national debt

Readings:
Money, Output, and the Nominal National Debt, Champ and Freeman, AER 1990
Sticky Prices vs. Sticky Wages: A Debate Between Miles Kimball and Matthew Rognlie, 2013
The Sticky Price Hypothesis: A Critique, Andolfatto 2010
Just How Helpful is Inflation? Hamilton 2013
Beyond Inflation Targeting: Should Central Banks Target the Price-Level, Kahn 2009



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).

Lecture slides: Money, bonds, and banking

Readings:
Taking intermediation seriously, Andolfatto 2003
On the coexistence of money and bonds, Andolfatto 2005
Banking crises in monetary economies, Jiang, CJE 2008
The curse of advanced economies in resolving banking crises, Laeven and Valencia, 2012


THE LIQUIDITY TRAP
An application of our model to Japan.

Lecture slides: The liquidity trap

Reading:
Monetary implications of the Hayashi-Prescott hypothesis for Japan, Andolfatto 2003
Non-performing loans, prospective bailouts, and Japan's slowdown, Barseghyan, JME 2010 (optional)


ASSET PRICES AND EMPLOYMENT
Narayana Kocherlakota discovers the IS curve via a sticky nomimal wage.

Lecture slides: Asset prices and employment

Reading:
Impact of a Land Price Fall when Labor Markets are Incomplete, Kocherlakota 2013



STICKY REAL WAGES

Lecture based on: Wage rigidities and jobless recoveries, Andolfatto 2010

Readings:
Wage rigidities and jobless recoveries, Shimer 2012

Is wage rigidity the problem? Andolfatto 2012


THE TAYLOR RULE
See: Taylor rule

Lecture based on: Is it time for the Fed to raise its policy rate? Andolfatto 2013
Lecture: Fed balance sheet, Andolfatto 2013

Readings:
The making of a great contraction with a liquidity trap and a jobless recovery, Schmitt-Grohe and Uribe, 2012
Seven faces of the "peril" Bullard, 2010
The perils of Taylor rules, Benhabib, Schmitt-Grohe and Uribe, JET 2001 (optional)
Tight monetary policy on the loose: A fiscalist hyperinflation, Loyo 1999 (optional)


INTERNATIONAL MONETARY SYSTEMS

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)
Lecture slides: Understanding sovereign debt crises (Andolfatto)
Problem Set: The free-rider problem.

Reading 4: Euro Explosion (Cochrance, 2012)
Reading 5: Revenge of the Optimum Currency Area (Krugman, 2012)
Reading 6: The Canadian Fiscal Union: Lessons for the Eurozone? (Gordon, 2012)
Reading 7: Interdependence of Fiscal Debts in the EMU (Demertzis and Viegi, 2011)

Reading 8: Global Imbalances: Good for the World? (Andolfatto, 2010)
Reading 9: Liquidity Shocks, Real Interest Rates, and Global Imbalances (Andolfatto, 2012)

Reading 10: Self-fulfilling debt crises (Cole and Kehoe, 1999) (optional)

Lecture slides: Sovereign Debt: A Modern Greek Tragedy (Waller, 2012)
Lecture slides: The Euro Area Crisis (Orphanides 2013)


THE PAYMENTS SYSTEM

Lecture slides: The payments system (Andolfatto)

Reading: Relevant chapter from Champ, Freeman and Haslag

END OF COURSE MATERIAL 2013


Financial accelerator
OLG search model
Credit constraints OLG
Miles Kimball: Institutional realities of housing construction

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Summer 2012

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.

Reading 1: Introduction (Andolfatto)
Reading 2: Asset Shortages and Price Bubbles: A New Monetarist Perspective (Andolfatto)
Reading 3: Fiat Money in Theory and in Somalia (Andolfatto)
Reading 4: Private Money in our Past, Present, and Future (Champ, 2007)

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.

Reading 1: Modeling Monetary Economies, Chapters 1 and 3, Champ, Freeman, and Haslag
Reading 2: Notes on the Overlapping Generations Model (Wright)
Reading 3: A Model of Fiat Money (Andolfatto, 2008)

Lecture slides: Money and Capital in the OLG Model (Andolfatto)
Application 1: Interpreting Recent Movements in the Money Supply and Price-Level (Andolfatto, 2010)
Application 2 : Monetary Implications of the Hayashi-Prescott Hypothesis for Japan (Andolfatto, 2003)

Lecture slides: Money, Output, and the Nominal National Debt (Champ and Freeman, AER 1990)
Application 1: NGDP Targeting in an OLG Model (Andolfatto)
See also: NGDP Targeting in an OLG Model (Another Try)

Supplementary reading 1: Understanding NGDP Targeting (Economist)
Supplementary reading 2: The Case Against the Case for NGDP Targeting (Economist)
Supplementary reading 3: Efficient Rules for Monetary Policy (Ball, 1996)
Supplementary reading 4: Understanding NGDP Targeting (Bradley and Jansen, 1989)
Supplementary reading 5: Some Doubts About NGDP Targeting (Williamson, 2012)

Advanced Readings (optional)
Stationary Sunspot Equilibria in a Finance Constrained Economy (Woodford, Journal of Economic Theory, 1986).
Public Debt as Private Liquidity (Woodford, American Economic Review, 1990)

3. International Money Systems

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)
Problem Set: The free-rider problem.

Reading 4: Euro Explosion (Cochrance, 2012)
Reading 5: Revenge of the Optimum Currency Area (Krugman, 2012)
Reading 6: The Canadian Fiscal Union: Lessons for the Eurozone? (Gordon, 2012)
Reading 7: Interdependence of Fiscal Debts in the EMU (Demertzis and Viegi, 2011)

Reading 8: Global Imbalances: Good for the World? (Andolfatto, 2010)
Reading 9: Liquidity Shocks, Real Interest Rates, and Global Imbalances (Andolfatto, 2012)

Lecture slides: Sovereign Debt: A Modern Greek Tragedy (Waller, 2012)

4. Banking

Reading 1: Ron Paul's Money Illusion (Sequel) (Andolfatto, 2011)
Reading 2: Fractional Reserve Banking (Andolfatto, 2011)
Reading 3: Out of Thin Air? (Andolfatto, 2011)

Reading 4: What is Money? How is it Created and Destroyed? (Andolfatto, 2009)
Reading 5: Notes on the Theory of Money and Banking (Andolfatto, 2008)
Reading 6: Taking Intermediation Seriously: A Comment, (Andolfatto, 2003)
Reading 7: Money, Capital, and Banking (Andolfatto, 2008)
Reading 8: Banking Crises in Monetary Economies, (Jiang, 2008)

Reading 9: The Diamond and Dybvig Bank Run Model (Andolfatto, 2008)
Reading 10: Calomaris and Kahn's Theory of Demandable Debt (Andolfatto, 2008)

Video 1: The Leverage Cycle: Causes and a Cure for the Current Crisis (John Geanakoplos, 2011)
Reading 9: Discussion of "The Leverage Cycle" (Hyun Song Shin, 2009)

Reading 10: Money: What is the Question and Why Should We Care About the Answer (Kocherlakota)

Additional Readings (optional)
A Dynamic Analysis of an Economy with Banking Optimization and Capital Adequacy Requirements (Miyake and Nakamura, JEB 2007)
New Evidence on the Free Banking Era (Rolnick and Weber, AER 1983)
George Selgin on Replacing the Fed (Andolfatto, 2010); and A Reply by George Selgin.
Money and Inflation (Andolfatto, July 21, 2010)
Is QE2 a Savior, Inflator, or Dud? (Cochrane, June 2, 2011); see also: Quantitative Easing (Cochrane)
Evidence on the Portfolio Channel of Quantitative Easing (Thornton, 2012)
Fiat Money and Coordination: A "Perverse" Coexistence of Private Notes and Fiat Money (Bryant, 2005) Lecture Slides (Andolfatto)


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.

Reading 1: The Simple Analytics of Money and Credit in a Quasilinear Environment (Andolfatto)
Advanced reading (optional): New Monetarist Economics: Methods (Williamson and Wright, 2011)

Lecture slides: Basic Quasilinear Model
Lecture slides: Money in a Quasilinear Model

6. Asset Pricing

Reading 1: On the Social Cost of Transparency in Monetary Economies (Andolfatto)
Lecture slides: Chicago2009 (Andolfatto)

Reading 2: A Note on the Societal Benefits of Illiquid Bonds (Andolfatto, CJE)

Reading 3: The Limits of Arbitrage (Shleifer and Vishny, JF 1995)
Reading 4: LAPM: A Liquidity-Based Asset-Pricing Model (Holmstrom and Tirole, JF 2001)


******** ASSORTED MATERIALS FROM PAST COURSES ******************

A useful reading list (Georges)

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)

References:
Here is a list of papers that apply this general framework to various questions (c. 2008)

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.)

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.