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A Theory of Money and Banking

By David Andolfatto

Abstract

We construct a very simple environment where an institution, which closely resembles a bank, endogenously arises. In our model a bank is an agent that: (1) creates money (a debt instrument that circulates as a means of payment); (2) lends it out (swapping it for less liquid forms of debt); (3) monitors those agents in control of the capital backing the illiquid debt; and (4) collects on money loans as they come due. Bank money in our model is a debt instrument that embeds within it important stipulations that are found in actual private money instruments. We show that when trade is decentralized a Pareto efficient allocation can only be achieved if a bank is present. Our model goes some way in addressing the questions of why private money takes the form that it does, as well as why private money is typically supplied by banks. 1

Year: 2003
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