a1 Queen's University
This paper presents an integrated theory of money and dynamic credit. I study financial intermediation when both the intermediary and individuals have private information. I show that money is essential to solving two-sided incentive problems under the dynamic credit arrangement. First, requiring settlement with money can induce market trades that generate information-revealing prices to discipline the intermediary. Second, it is optimal for the intermediary to issue money that can record its own history of being used in settlements, and to require that settlements be made with only money that has been returned to the intermediary every settlement period. This arrangement effectively reduces individuals' incentives to deviate and allows intermediation to achieve efficient allocations.
(Online publication October 26 2010)
A previous version of this paper was circulated under the title “Banking, Inside Money and Outside Money” (Sun 2007b). I am grateful to Shouyong Shi for guidance and inspiration. I thank the editor and an anonymous referee for insightful comments and suggestions. I have also benefited from conversations with seminar and conference participants at the University of Toronto, the 2006 Midwest Macroeconomics Meetings, the 2006 Annual Meeting of the Canadian Economic Association, the 2006 Cleveland Fed Summer Workshop on Money, Banking and Payments and the 2006 Research on Money and Markets Workshop. This research was partly supported by Shouyong Shi's Bank of Canada Fellowship. However, the opinions expressed here are my own and do not reflect the views of the Bank of Canada. I also gratefully acknowledge financial support from the Social Sciences and Humanities Research Council of Canada. All errors are my own.