Optimal public money

In most countries, the supply of paper money is controlled by a state institution. This paper provides an explanation for why such an arrangement is typically chosen. I use a deterministic matching model with a continuum of agents where enforcement is limited and where some agents produce public goods. Agents can also, at a cost, produce a distinguishable, intrinsically useless but perfectly durable good: notes. I call a note public if it is printed by an agent who produces public goods. In this framework, I prove that the socially optimal allocation is only implemented by a pattern of trade in which exchanges are effected using public notes. JEL Classification: D8, E5Limited Commitment, Money

Let's make it clear: how central counterparties save(d) the day

The bankruptcy of Lehman Brothers in 2008 will certainly be featured in history books as one of the greatest financial failures so far, but it will also be recorded as yet another episode of the historically successful performance of clearing arrangements in ensuring the resiliency of markets. Recognizing the usefulness of safe and sound clearing and settlement procedures, the Federal Reserve has recently supported the attempt to shift the clearing of some contracts to a central counterparty. In this article, Cyril Monnet outlines the arguments in favor of central counterparty clearing, the economic rationale for trade clearing through a central counterparty, and some possible limits to the advantages of clearing trades through a central counterparty.Bankruptcy ; Risk

Rehypothecation

How would you feel if even though you were making regular monthly payments, your mortgage bank sold your house? This may seem like an odd question, but this type of situation happens every day in financial markets in a practice known as rehypothecation. Although such practices may be hard for nontraders to understand, rehypothecation is widespread in financial markets. Following the crisis of 2007-2009, the Dodd-Frank Act put restrictions on rehypothecation for derivatives. To understand the scope of these restrictions, we need to understand the role of rehypothecation in financial trades. In this article, Cyril Monnet discusses questions such as: Which party to a financial trade does rehypothecation benefit? Are there limits to its advantages? And how should it be regulated? There are no hard and fast answers to the last question, but the author notes that we can make a more informed decision about the pros and cons of various forms of regulation if we understand the underlying economics.Financial markets ; Financial Regulatory Reform (Dodd-Frank Act)

Counterfeiting and inflation

In this paper I show that a lax anti-counterfeiting policy is inconsistent with price stability. I use a deterministic matching model with no commitment and no enforcement. An intrinsically worthless but perfectly durable object called a ‘note’ can be produced by banks at a given cost, but also by nonbanks at a (possibly) higher cost. Counterfeiting occurs when nonbanks produce notes in equilibrium. When it is cheap for nonbanks to produce notes, or the technology used to detect counterfeits is poor, counterfeits are circulating in equilibrium and trade is only implemented with a growing stock of notes (thus creating inflation). Finally, I show that the highest welfare level is achieved when counterfeiting is costly, or when the detection of counterfeits is of high quality. JEL Classification: D8, E5Counterfeiting, inflation, Limited Commitment, Money

Central counterparties

Central counterparties (CCPs) have increasingly become a cornerstone of financial markets infrastructure. We present a model where trades are time-critical, liquidity is limited and there is limited enforcement of trades. We show a CCP novating trades implements efficient trading behaviour. It is optimal for the CCP to face default losses to achieve the efficient level of trade. To cover these losses, the CCP optimally uses margin calls, and, as the default problem becomes more severe, also requires default funds and then imposes position limits

Optimal Monetary Policy in a Channel System of Interest-Rate Control

This paper studies optimal interest-rate policies when the central bank operates a channel system of interest-rate control. We conduct our analysis in a dynamic general equilibrium model with infinitely-lived agents who are subject to idiosyncratic trading shocks which generate random liquidity needs. In response to these shocks agents either borrow against collateral or deposit money at the central bank at the specified rates. We show that it is optimal to have a strictly positive interest-rate corridor if the opportunity cost of holding collateral is strictly positive and that the optimal corridor is strictly decreasing in the collateral's real returnOptimal Monetary Policy, Channel System, Interest Rate Rule, Essential Money

Why do financial systems differ? History matters

We describe a dynamic model of financial intermediation in which fundamental characteristics of the economy imply a unique equilibrium path of bank and financial market lending. Yet we also show that economies whose fundamental characteristics have converged may continue to have very different financial structures. Because setting up financial markets is costly in our model, economies that emphasize financial market lending are more likely to continue doing so in the future, all else equal. JEL Classification: L16, G10, G20, N20banks, convergence, Financial Institutions, financial markets, Financial Systems

Optimal contracts in a dynamic costly state verification model

This paper describes optimal contracts in a dynamic costly state verification model with stochastic monitoring. An agent operates a risky project on behalf of a principal over several periods. Each period, the principal can observe the revenues from the project provided he incurs a fixed cost. We show that an optimal contract exists with the property that, in each period and for every possible revenue announcement by the agent, either the principal claims he entire proceeds from the project or promises to claim nothing in the future. This structure of payments enables the principal to minimize audit costs over the duration of the project. Those optimal contracts are such that the agent's expected income rises with time. Moreover, except in at most one period, the principal claims the entire returns of the project whenever audit occurs. We also provide conditions under which all optimal contracts must satisfy hese properties JEL Classification: D8, C7Costly State Verification, Dynamic Contracts, Monitoring, Theory of Uncertainty and Information

Monetary Policy in a Channel System

Channel systems for conducting monetary policy are becoming increasingly popular. Despite their popularity, the consequences of implementing policy with a channel system are not well understood. We develop a general equilibrium framework of a channel system and investigate the optimal policy. A novel aspect of the channel system is that a central bank can "tighten" or "loosen" its policy without changing its target rate by increasing the interest-rate spread symmetrically around the target rate. This questions the characterization of optimal policy through interest-rate rules, as done in a large body of the literature on the optimal design of interest-rate rules.monetary policy, interest rates, search

Why do financial systems differ? History matters

We describe a dynamic model of financial intermediation in which fundamental characteristics of the economy imply a unique equilibrium path of bank and financial market lending. Yet we also show that economies whose fundamental characteristics have converged may continue to have very different financial structures. Because setting up financial markets is costly in our model, economies that emphasize financial market lending are more likely to continue doing so in the future, all else equal.Financial markets