Breaking the Curse of Cash
34 Pages Posted: 29 Apr 2018 Last revised: 16 Nov 2018
Date Written: November 13, 2018
Can eliminating large denomination bills improve social welfare? We construct a dual currency model to study whether illegal activity can be reduced or eliminated by modifying the payment environment. In our model, there are two types of money, coins and paper money, and two types of goods, legal and illegal. Legal (goods) traders are ex ante indifferent between coins and paper money, but illegal (goods) traders prefer paper money to coins because illegal activities can be detected by the noise of the coins. Eliminating paper money can improve social welfare by correcting the externality associated with illegal activity. However, this pooling equilibrium can be suboptimal when the externality is not sufficiently large. Given a government budget constraint, a separating equilibrium in which legal traders use coins and illegal traders use paper money, can improve welfare by making a transfer from the illegal traders to the legal traders.
Keywords: Dual Currency, Seigniorage, Externality
JEL Classification: D62, E26, E52
Suggested Citation: Suggested Citation