New Monetarism and Narrow Banking: Take Two

The new monetarist framework makes it possible to draw a distinction between two types of liquidity: monetary liquidity and market liquidity. First, observe that market liquidity is the type of liquidity that is modeled in a competitive equilibrium framework. Or to be more precise, because models of competitive equilibrium are driven by market clearing which by assumption converts individual demand and supply into a price-based allocation, they give us information about the kind of liquidity that derives from the meeting of demand and supply. Not only do prices change in such market models, but it is an essential aspect of market liquidity that prices must change in response to fundamental changes in supply and demand.

Of course, money is not essential in competitive equilibrium models and the new monetarist framework grew out of the project of figuring out how to make money essential. The short version of the outcome of this project (discussed at somewhat greater length in my first post on New Monetarism and Narrow Banking) is that money is essential in models where agents buy and sell at different points in time.

As I have argued elsewhere, an implication of new monetarism is that the competitive equilibrium framework can be easily augmented to make money essential. All that is necessary is to divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability. (Note that the demand for micro-foundations meant that I was required to introduce the monetary friction in the form of assumptions regarding endowments and preferences — that as far I as am concerned simply muddy the model.)

An important advantage of introducing this simplest of monetary frictions into competitive equilibrium models is that all the implications that have ever been drawn from such models are still valid given one proviso: they must explicitly assume that the process of providing within period (or short-term) credit is perfect. In short, careful use of new monetarist methods can be used to illuminate the assumptions underlying the concepts of competitive equilibrium and market liquidity.

Monetary liquidity is then the process of addressing the within period frictions. It becomes immediately obvious in this framework that cash is an inadequate means of addressing the monetary friction, because an endogenous cash-in-advance constraint is generated. Any agent who is assigned to buy first and doesn’t hold enough cash will be liquidity constrained. In this framework, it is essential to have enforceable short-term debt contracts in order to eliminate the monetary friction and have perfect provision of monetary liquidity.

This last point is why narrow banking proposals are misguided. They misconceive of what is necessary to have perfect provision of monetary liquidity. Cash or sovereign/central bank solutions to the monetary problem generate a cash-in-advance constraint. Only a form of money that includes short-term debt can fully address the monetary friction.


12 thoughts on “New Monetarism and Narrow Banking: Take Two”

  1. Carolyn: “Any agent who is assigned to buy first and doesn’t hold enough cash will be liquidity constrained. In this framework, it is essential to have enforceable short-term debt contracts in order to eliminate the monetary friction and have perfect provision of monetary liquidity.”

    I am unclear whether there is a sharp distinction between being liquidity constrained and being borrowing constrained.

    1. Each agent knows there is a chance he will be assigned to buy first next period, and so will hold some cash at the end of this period. But if the opportunity cost of holding cash is strictly positive, there is a strictly positive probability he will be liquidity constrained. There is less than Friedman’s optimal quantity of money. Sellers don’t trust his IOU, so he buys less goods than is optimal.

    2. A student wants to borrow to invest in human capital, but lenders don’t trust his IOU, so he buys less education than is optimal.

    1. Re: liquidity constrained vs. borrowing constrained.

      Within the model there is a sharp distinction, because in one case one is constrained in terms of borrowing on a short-term basis (within period debt) and in the other one is constrained in terms of borrowing on a long-term basis (across period debt).

      As applied to the real world, I would argue that even though there are “grey” cases, there are also a lot of examples that fall clearly into the “liquidity constrained” category. Basically when the flow of income is a “sure thing,” an agent is liquidity constrained if the agent can’t turn this anticipated flow of income into transactable liquidity immediately.
      An employee with direct deposit (assuming the bank receives immediate information if direct deposit is terminated) is liquidity constrained if s/he can’t borrow those funds a week or two ahead of the time at which they are paid.
      A business that has sold goods on credit is liquidity constrained if it cannot turn that trade credit into cash easily.

      The student, by contrast, is clearly engaged in a long-term calculation of future profitability, and therefore faces much more risk about the actual value of the investment. So the student is borrowing constrained.

      I think it’s a failure of modern terminology that we don’t have a separate category for this kind of debt that involves much less uncertainty than long-term debt. As long as the banking system is effectively monitoring debtors and eliminating cheaters from the short-term debt system, this kind of debt is extremely safe (though of course subject to disruption in a financial crisis).

      Another issue that arises (and that I haven’t spent enough time with Friedman to be sure that I understand completely) is this: “if the opportunity cost of holding cash is strictly positive, there is a strictly positive probability he will be liquidity constrained. There is less than Friedman’s optimal quantity of money.”

      The paper that I link to above ( ) explains that as long as agents have heterogeneous needs for liquidity, a monetary policy that is uniform across agents can’t implement a first-best outcome. The basic problem is that providing enough cash for the high-needs type is too much cash for the low-needs type. The first best can only be achieved by a government monetary policy that discriminates between all of the different types of agents.

      In some sense, eliminating the liquidity constraint for the high-needs type will be inflationary, because it requires providing too much liquidity to the economy. (Note that the paper doesn’t actually develop the intertemporal aspects of the problem enough to demonstrate this.)

      Debt-based money (along with the threat of being liquidity constrained if you default) solves this problem by ensuring that every agent only wants to borrow as much as that agent can pay back.

      1. I’m trying to get the intuition behind Proposition 4 in your paper.

        If the central bank paid interest on money, financed by lump sum taxes, wouldn’t you get the Pareto Optimal allocation in the limit, as the rate of interest paid on money approaches the rate of time preference?

      2. It’s been a long time since I’ve done work in this area, but I think that the reason the answer to your question is often assumed to be yes is because it is common for macroeconomists to work with models with complete markets. Whereas models with an essential role for money are always models of incomplete markets.

        I think that it is generally the case that when you combine heterogeneous agents with a form of incomplete markets that makes money valuable, the Friedman Rule can only be implemented with some form of type specific monetary policy. Thus, as long as “lump-sum taxes” are understood to be the same lump-sum tax for every agent in the economy, your policy rule cannot work to get a Pareto optimal allocation, even in the limit.

        This paper might be helpful to you on this issue:

        (If you’d asked me eight years ago, I would have had more confidence in my answers.)

      3. Since we finished this discussion over at your blog, I thought I’d add this conclusion/clarification for anyone who reads this thread.

        In an environment with heterogeneous agents, the Friedman rule can’t be implemented by uniform lump sum taxes. If the lump-sum ensures the right money holdings for low-needs agents, then high-needs agents are cash constrained, and if the lump sum ensures the right money holdings for high-needs agents, then the transversality condition is violated by the low-needs agents who are constantly carrying cash into the future and never spending it. This is why the Friedman rule is only implementable in a heterogeneous agent environment by a government that imposes a different lump-sum tax in each period on each type of agent.

        Note that as I understand it the Lagos-Wright model is designed to get around this “problem” by introducing a frictionless stage in which money balances are reallocated after every trading period with frictions. I by contrast interpret this situation not as a problem that needs to be solved by modeling techniques that get us back into the neo-classical framework, but as a problem that is solved by the development of a banking system.

  2. Off-topic: a simple question about bills of exchange.

    A issues a bill, uses it to buy goods from B, who endorses the bill and uses it to buy goods from C,….etc..Then Z takes the bill to A and demands payment in gold. A is unable to pay.

    Who does Z go to next to demand payment? Is it B, or Y?

    Does it matter?

    1. In the U.S. and Britain, Z gets to choose whether to demand payment from B or Y, as both of them are full guarantors on the debt. (Continental legal regimes may differ.)

      It matters only in the sense that the Anglo-American legal regime provides the greatest possible protection for the creditor, since, if you have to try to collect in a certain order, it may be very inconvenient to chase down all of the parties who endorsed the bill.

      1. Thanks. (It’s embarrassing I know so little about bills of exchange. I remember reading a little about them in monetary history, but never really understood them. JP Koning had a couple of posts about them on his blog. The bank strike in Ireland is one place they reappeared recently; A would write a cheque to pay B, B would endorse it and use it to pay C,…etc., so that cheques were circulating until the bank strike ended.)

      2. Thank you for the information on the Irish bank strikes. I was not familiar with this use of negotiable paper.

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