Elsevier

Journal of Economic Theory

Volume 164, July 2016, Pages 166-186
Journal of Economic Theory

Monetary policy with asset-backed money

https://doi.org/10.1016/j.jet.2015.08.006Get rights and content

Abstract

We study the use of asset-backed money in a neoclassical growth model with illiquid capital. A mechanism is delegated control of productive capital and issues claims against the revenue it earns. These claims constitute a form of asset-backed money. The mechanism determines (i) the number of claims outstanding, (ii) the dividends paid to claim holders, and (iii) the structure of redemption fees. We find that for capital-rich economies, the first-best allocation can be implemented and price stability is optimal. However, for sufficiently capital-poor economies, achieving the first-best allocation requires a strictly positive rate of inflation. In general, the minimum inflation necessary to implement the first-best allocation is decreasing in capital wealth.

Introduction

The end of Bretton Woods in 1971 ushered in the era of fiat currencies. This decoupling of currency from a commodity standard raised many issues among economists, such as price-level determinacy, the optimal rate of inflation, and most importantly, who should be in charge of the monetary system – the government or the private sector? Friedman (1969), Klein, 1974, Klein, 1976, and Hayek (1976) argued strenuously that privately managed monetary arrangements were feasible and would lead to the best economic outcomes. Under this system, a commodity-backed private currency would pave the way to price stability – that is, zero inflation. The main point of contention was whether or not it is essential in such a system for a government to provide a monopoly currency. In short, the debate centered on whether a government fiat currency offers unique advantages.

The inflation of the 1970s rekindled this debate in the 1980s, as reflected in the work by Barro (1979), King (1983), Wallace (1983), Sargent and Wallace (1983), and Friedman and Schwartz (1986). Again, the discussion on private monetary systems focused on commodity money backed by gold or silver. However, Fama (1983) argued that asset-backed claims were sufficient and actually offered advantages over a specie-backed currency. According to this arrangement, the financial intermediary would not issue liabilities redeemable in specie, since the claims would be equity claims. The financial intermediary was simply a conduit for transferring the returns on the underlying assets to the claim holders. Nevertheless, Fama argues that due to information and computation costs, fiat currency would still be needed for “hand-to-hand” transactions. While the Great Moderation and the decline in worldwide inflation since the early 1980s caused the profession to lose interest in this topic, the recent financial crisis has led to renewed public debate on the necessity of having a government fiduciary currency, most notably from the “End the Fed” supporters in the United States.

Although the literature on privately managed monetary systems focuses on many dynamic issues such as price stability, surprisingly, none of this work has used choice theoretic, dynamic general equilibrium models.1 Much of the analysis is static, purely intuitive, or focuses on historical episodes. Another problematic issue is that the underlying frictions giving rise to the need for currency were not well specified. This was an obvious problem recognized early as evidenced by Helpman's (1983, p. 30) discussion of Fama's paper:

The argument for an uncontrolled banking system is made on efficiency grounds by means of the frictionless neoclassical model of resource allocation. But this framework does not provide a basis for arguing the desirability of price level stabilization. If indeed stabilization of the price level is desirable, we need to know precisely what features of the economy lead to it. Then we have to examine whether such features make an uncontrolled banking system desirable. This problem is of major importance, but it is not addressed in the paper.

Modern monetary theory has made clear progress in addressing Helpman's critique of Fama's work by specifying the frictions needed to make a medium of exchange essential for trade.2 Furthermore, due to advances in macroeconomic and monetary theory, we are now able to use choice theoretic, dynamic general equilibrium models to revisit these issues. These tools allow us to address a variety of questions regarding the impact of an asset-backed money (ABM) on the real economy and the price level. For example, is price-level stability desirable? More generally, how should the monetary instrument be designed and managed to achieve a good allocation? Our objective in this paper is to build a macroeconomic model to provide answers to questions of this nature.

We use the Aruoba and Wright (2003) neoclassical growth model to study the use of intermediated assets as media of exchange. As in Lagos and Wright (2005), a medium of exchange is needed for some transactions. Physical capital is assumed to be illiquid and thus cannot serve directly as a medium of exchange. However, rather than fiat currency, we assume that a mechanism is delegated control of the stock of physical capital and issues equity claims against the revenues that it earns. These claims are used as a medium of exchange and constitute a form of ABM.3 The mechanism consists of a set of rules that specifies (i) the number of claims outstanding, (ii) the dividends paid out to claim holders, and (iii) the redemption fee charged for disbursing the dividend.

We focus our attention on implementing first-best allocations. We find that for capital-rich economies, the first-best allocation can be implemented and price stability is optimal as Fama suggested. However, for sufficiently poor economies, achieving the first-best allocation requires a strictly positive inflation, which in our model is equivalent to a policy of persistent (and predictable) dilution of the outstanding stock of ABM.

Aruoba and Wright (2003) assume that physical capital is illiquid in the sense that capital cannot be used as a payment instrument in the goods market. To facilitate trade in that market, a new asset is introduced – a fiat money object (more generally, government debt) that is assumed to be liquid. As is standard, they find that the Friedman rule is an optimal policy. That is, if lump-sum taxation is available, then it should be used to contract (deflate) the money supply to generate an efficient real rate of return on money. Lagos and Rocheteau (2008) modify the Aruoba and Wright (2003) model by permitting capital to circulate as a payment instrument. In some cases, capital is over-accumulated and the introduction of a second asset – again, fiat money or government debt – can improve efficiency. The optimal policy is again the Friedman rule.

Our approach contrasts with the previous two papers in the following ways. First, we assume that capital is illiquid, but that intermediated claims to capital are not. This assumption is innocuous if the stock of ABM is fixed. However, we allow the stock of ABM to change over time. This is one distinction between our paper and Lagos and Rocheteau (2008).4 Second, we do not (although we could) introduce a second asset (such as fiat money or government debt). Consequently, monetary policy in our model is restricted to managing the supply of ABM. Third, first-best implementation in our model is possible even without lump-sum taxes in capital-poor economies. Fourth, we find that an optimal mechanism may require inflation – which is equivalent to a policy of persistent (and predictable) dilution of the outstanding stock of ABM.

Our paper is also related to Andolfatto (2010) who abstracts from capital. He finds that an incentive-feasible policy rules out deflation and price stability is sufficient to implement the first-best allocation in sufficiently patient economies. In our model, the minimum inflation necessary to implement the first-best allocation is decreasing in the capital stock. As a consequence, the first-best allocation can be achieved with moderate deflations in capital-rich economies. However, in capital-poor economies inflation is necessary to attain the efficient allocation.

Although we have only one medium of exchange, our paper is related to a body of research that studies the coexistence of fiat money and other assets as media of exchange. This literature finds that if a real asset can be used as a medium of exchange and its fundamental value is sufficiently high, then the first-best allocation can be obtained. However, if the fundamental value is too low, the real asset will carry a liquidity premium and the first-best allocation will be unattainable (see Waller, 2003, Waller, 2011, Geromichalos et al., 2007, Lagos and Rocheteau, 2008). It then follows that introducing a second asset (typically fiat money) to reduce this liquidity premium will lead to better allocations. Thus, fiat money is essential even though real assets are available as exchange media. With respect to this literature, we are able to show that even when the fundamental value is too low, mechanisms can be designed to attain the first-best allocation without the need for a second asset.

Using a mechanism design approach, Hu and Rocheteau (2014) gain additional insights into the coexistence issue. They investigate the coexistence of fiat money and higher-return assets in an economy with pairwise meetings, where fiat money and risk-free capital compete as means of payment. They find that in any stationary monetary equilibrium, capital has a higher rate of return than fiat money. In Hu and Rocheteau (2015), they study the effects of monetary policy on asset prices. Although some research questions are similar to ours, such as which conditions are necessary for first-best allocations to be obtained, our paper differs from this literature in that we do not study coexistence issues, since we restrict attention to cases where a single exchange medium is sufficient.5

Section snippets

Environment

Our environment is based on Aruoba and Wright (2003). Time t is discrete and the horizon is infinite. Each period is divided into two subperiods, which we refer to below as the AM and PM (subperiods), respectively. There is a [0,1] mass of ex ante identical agents with preferences given byE0t=0βt{σ[u(qtc)qt]+θU(Ct)+NNt}.

Agents are randomly assigned to one of three states in the AM: consumers, producers, or idlers. The probability of becoming a consumer is σ, the probability of becoming a

Asset-backed money

Aruoba and Wright (2003) examine the properties of equilibria under the assumptions that (i) agents are anonymous; (ii) capital cannot be used as a payment instrument in the AM market; and (iii) there is a fiat money instrument that can be used as a payment instrument in the AM market; and (iv) the government has access to a lump-sum tax instrument. They find that the Friedman rule (i.e., to deflate at the rate of time preference) is an optimal policy.

In this paper, we maintain assumptions (i)

Individual decision-making

We now drop time subscripts from our notation. Any variable without a time subscript is to be understood as a contemporaneous variable. A “one-period ahead” variable xt+1 will have the notation x+. Likewise, we denote xt1 as x.

Stationary ABM equilibrium

For a given mechanism, we focus on symmetric stationary equilibria. Such equilibria meet the following requirements: (i) Households' decisions are optimal; (ii) the decisions are symmetric across all sellers and symmetric across all buyers; (iii) markets clear at every date, and (iv) all real quantities are constant across time. In particular, the aggregate real value of outstanding ABM is constant: ϕ2M=ϕ2M such that ϕ2=μϕ2.

We now gather the restrictions implied by individual behavior. We

Optimal mechanisms

We now study the properties of mechanisms that are consistent with a first-best implementation (i.e., the implementation of the first-best allocation as a competitive equilibrium). In what follows, we restrict attention to mechanisms that are programmed to start with a capital stock K=K(θ). For arbitrary mechanisms (in our class of mechanism) with these properties, the level of economic activity in the AM, q, may or may not be efficient. The goal is to identify the additional properties needed

Conclusion

When commitment and record-keeping are limited, media of exchange are necessary to facilitate trade. Exactly what form these exchange media should take and how their supply should be managed over time remain open questions. In theory, a properly managed supply of fiat money may be sufficient, but as shown in this paper, fiat money is generally not necessary. The concept of monetary policy should be extended to include the management of intermediated exchange media such as asset-backed money.

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    The views expressed are those of the individual authors and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors. Andolfatto: Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166-0442. Berentsen: Economics Department, University of Basel, Peter-Merian-Weg 6, Postfach, CH-4002 Basel, Switzerland. Waller: Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166-0442.

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