Scott Freeman

Clearinghouse banks and banknote over-issue

Abstract The paper presents a model of banks as clearinghouses of private debt where money is used as the means of payment. Implications of the model include: i) the private provision of banknotes or a discount window may be needed to avoid the insufficient debt clearing that results from an inflexible currency stock; and ii) an uncontrolled total money stock may result in a multiplicity of equilibria including an inflationary banknote over-issue.

Rediscounting under aggregate risk

Abstract This paper compares three institutions that offer an elastic currency – open market operations, a discount window, and a private, banknote-issuing clearinghouse – in an economy with financial markets otherwise hampered by a lack of liquidity. When this economy is subject to aggregate financial shocks, these alternative forms of central banking are shown to differ in their implications for risk-sharing. Interesting implications include (i) central bank losses and monetary innovations that are part of an efficient equilibrium; and (ii) desirable quantity restrictions at the discount window.

Resolving Differences over the Optimal Quantity of Money

OPTIMAL STEADY-STATE MONETARY POLICY in models of infinitely lived agents calls for a deflation of the fiat money stock at a rate that equates the rates of return of fiat money and capital. This prescription for the optimal quantity of money holds whether the demand for money springs from placing money in the utility function (Friedman 1969), a cash-in-advance constraint (Grandmont and Younes 1973), or spatial separation (Townsend 1980). In contrast, monetary models of overlapping generations have counseled the (golden rule) optimality of a fixed stock of fiat money. 1 This model has often been criticized for its lack of a transactions role for money that would distinguish itself from other assets.2 The seeming difference in this models implications concerning the optimal quantity of money thus raises an obvious question.3 Does the overlapping-generations model obtain different welfare implications because it assumes a finite lifespan or because it lacks a special transactions role for money? Recent work has reexamined the optimal quantity of money in overlappinggenerations models featuring transactions roles for money. Abel (1987), who takes the broadest and clearest look, finds that the golden rule optimal monetary policy,

Redemption Costs and Interest Rates under the U.S. National Banking System

Interest rates under the U.S. National Banking System (1863-1914) appear to imply that banks failed to exploit an arbitrage opportunity for two reasons: yields on government bonds exceeded the tax rate on note issue by approximately 150 basis points, and short-term interest rates varied seasonally. This paper examines whether note redemption costs can explain observed interest rates. We present a model in which redemption costs create a spread between the tax rate on note issue and bond yields and in which temporary seasonal fluctuations in currency demand generate seasonal movements in short-term interest rates. Calibration of the model to actual data lends support to the models implications. Further, interest rates are shown not to vary seasonally when banks do not incur the costs of note redemption.

On the optimality of interest-bearing reserves in economies of overlapping generations

SummaryPaying interest on required reserves is considered in an overlapping generations model in which the return to capital dominates the return to fiat money. As Smith (1991) showed, financing interest on reserves benefits the initial old at the expense of future generations. We show that the transfer of wealth associated with interest on reserves can be offset by an accommodating open market purchase, so that the payment of interest on reserves is a Pareto improvement. We also show that paying interest on reserves improves welfare even when financed by distorting taxes on capital.

The Enforcement of Property Rights and Underdevelopment

This paper formalizes the role of legal infrastructure in economic development in a general equilibrium model with endogenously determined property rights enforcement. It illustrates the mutual importance of property rights protection and market production by the model`s multiplicity of equilibria. In one equilibrium, property rights are enforced and market activity is unhampered. In the other, property rights are not enforced, which discourages economic activity and leaves the economy without the resources and incentives to enforce property rights. Even identically endowed economies may therefore find themselves in very different equilibria.

Monetary Policy in Low-Inflation Economies: The Welfare Cost of Inflation in the Presence of Inside Money

In this paper, we ask what role an endogenous money multiplier plays in the estimated welfare cost of inflation. The model is a variant of that used by Freeman and Kydland (2000) with inside and outside money in the spirit of Freeman and Huffman (1991). Unlike models in which the money–output link comes from either sticky prices or fixed money holdings, here prices and output are assumed to be fully flexible. Consumption goods are purchased using either currency or bank deposits. Two transaction costs affect these decisions: One is the cost of acquiring money balances, which is necessary to determine the demand for money and to make the velocity of money endogenous. The other is a fixed cost associated with using deposits. This cost is instrumental in determining the division of money balances into currency and interest-bearing deposits. Faced with these two costs and factors that may vary over time in equilibrium (such as over the business cycle), households make decisions that, in the aggregate, determine the velocity of money and the money multiplier. The model is consistent with several features of U.S. data: (1) M1 is positively correlated with real output; (2) the money multiplier and depositto-currency ratio are positively correlated with output; (3) the price level is negatively correlated with output in spite of conditions (1) and (2); (4) the correlation of M1 with contemporaneous prices is substantially weaker than the correlation of M1 with real output; (5) correlations among real variables are essentially unchanged under different monetary policy regimes; and (6) real money balances are smoother than money-demand equations would predict. A key feature of the model is that households purchase a continuum of types of goods indexed by their size. It comes from assuming a Leontief-type utility function over these types. One could argue that the distinction between nondurable and (usually larger) durable consumption goods should also be taken into account. We shall not take that step here. Instead, compared with Freeman and Kydland (2000), we consider a more flexible utility function than before, which, in equilibrium, permits the implication that households wish to consume large goods in relatively greater quantities.

Modeling Monetary Economies: Money Stock Fluctuations

WE OBSERVE IN real-world data a great deal of fluctuation in our measures of the money stock. Why is this so? Are central banks playing with the money stock, capriciously increasing or decreasing it? To this point in our studies, the government has determined the nominal stock of money through its complete control over the monetary base and reserve requirements. We observe, however, that central banks often miss the announced targets for the money stock. Are the people in charge hopelessly incompetent, or have our models overlooked some important source of fluctuation in the money stock? By definition, the total money stock is the product of the monetary base and the money multiplier. Observable changes in the money stock that do not come from changes in the monetary base must result from changes in the money multiplier. If the money multiplier is random, a central bank cannot exactly predict the total money supply even though it knows how much money is has printed (the monetary base). In Chapter 8, the money multiplier was found to be simply the inverse of the reserve requirement. Because reserve requirements rarely change (and would be well known to the central bank), they cannot be the source of the observed fluctuations in the money multiplier. Something else must be responsible. Figure 9.1 plots quarterly money multiplier data for the U.S. economy. Note the patterns in the money multiplier in relation to recession years (shaded regions of the graph).