Imperfect Monitoring and the Discounting of Inside Money

44 Pages Posted: 12 Dec 2005

See all articles by David C. Mills

David C. Mills

Board of Governors of the Federal Reserve System

Date Written: November 2007

Abstract

One of the fundamental questions concerning inside money is whether its issuers should be regulated and how. This paper evaluates the efficiency of one prevalent regulatory recommendation - a requirement that private issuers redeem inside money on demand at par - in a random-matching model of money where the issuers of inside money are only imperfectly monitored. I find that for sufficiently imperfect monitoring, a par redemption requirement leads to lower social welfare than if private money were redeemed at a discount. A central message of the paper is that if inside money and outside money are not perfect substitutes for one another, as is the case if there is sufficiently imperfect monitoring, a par redemption requirement may not be socially optimal because such a requirement effectively binds them to circulate as if they are. Such an outcome is a version of Gresham's law that bad money drives out good money.

Keywords: nside and outside money, electronic money, imperfect monitoring, Gresham's law

JEL Classification: E40, E42

Suggested Citation

Mills, David C., Imperfect Monitoring and the Discounting of Inside Money (November 2007). FEDS Working Paper No. 2007-58, Available at SSRN: https://ssrn.com/abstract=868507 or http://dx.doi.org/10.2139/ssrn.868507

David C. Mills (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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