Limited Commitment and the Legal Restrictions Theory of the Demand for Money

33 Pages Posted: 21 Jan 2013 Last revised: 24 Jan 2014

See all articles by Leo Ferraris

Leo Ferraris

Universidad Carlos III de Madrid

Fabrizio Mattesini

University of Rome Tor Vergata - Faculty of Economics

Date Written: December 18, 2012

Abstract

This paper addresses the "rate of return" puzzle of monetary theory. Similarly to the legal restrictions theory of the demand for money, we assume that Government bonds are subject to a minimum purchase requirement. Differently from this theory, however, we assume that intermediaries, when issuing private notes, cannot commit to always redeem them. First, we study an environment with legal restrictions to intermediation and show that cash and interest bearing bonds both circulate in the economy. Then, we drop the legal restrictions and show that also with active intermediation, under limited commitment, there is an equilibrium with rate of return dominance. A positive interest rate provides the intermediaries with the incentive to issue and redeem their notes.

Keywords: Money, Government Bonds, Rate of Return Dominance, Legal Restrictions

JEL Classification: E40

Suggested Citation

Ferraris, Leo and Mattesini, Fabrizio, Limited Commitment and the Legal Restrictions Theory of the Demand for Money (December 18, 2012). CEIS Working Paper No. 262, Available at SSRN: https://ssrn.com/abstract=2204490 or http://dx.doi.org/10.2139/ssrn.2204490

Leo Ferraris (Contact Author)

Universidad Carlos III de Madrid ( email )

CL. de Madrid 126
Madrid, Madrid 28903
Spain

Fabrizio Mattesini

University of Rome Tor Vergata - Faculty of Economics ( email )

Via Columbia n.2
Rome, rome 00100
Italy

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