lOMoAR cPSD| 45211451
CHAP 8 Modeling Monetary Economies
4th Edition
MONEY AND BANKING
, lOMoAR cPSD| 45211451
Chapter 8
Liquidityand Financial Intermediation
1 Roadmap
In Chapter 7, started with new storesof value that were
perfect substitutes for fiat money. In these economies, we learned
that if the rate of return on other assetsis greater than
that of fiat money, fiat money will not be valued. Yet,
when you look around, you see that fiat money is valued
in many real economies even though other assets, like capital, have
a greater return than fiat money. One way to get
money and capital to coexist is to assume the return
on capital is riskier than the return on money.
Here, we consider the additional possibility that fiat money is
valued because it is more liquid than alternative assets.
To incorporate liquidity into the basic framework, we add an extra
period to a person’s life. With three-period-lived people, liquidity
is easy to characterize: a store of value is more liquid if
it can be turned into the consumption good at any time
in a person’s life at the lowest cost. After presenting a
model economy in which liquidity differences exist, we talk
about banks as a means of overcoming liquidity problems. A
bank, or any financial intermediary, is a private company
that can arrange to offer peoplea liquid substitute for fiat
money. Why might it wish to do so? The difference in the rate
of return of liquid and illiquid assetsopensup an
opportunity for profits through arbitrage – by borrowing at the
low rate of return of money while investing at the high rate
of return of the illiquid asset.
As we develop these topics, there is an important friction
that keeps people from doing a bank’s jobs on their own.
Specifically, we do not allow people to create their own
, lOMoAR cPSD| 45211451
paper claims that would allow them to effectively sell part of
their capital. The information problem arises because it is
assumed to be too costly for anyone to verify that such a
claim is valid or not.
2 Money as a Liquid Asset
As we saw in Chapter 7, if fiat money and other
assetswere perfect substitutes, people would value only the asset with
the greater rate of return. To explain why fiat money
is valued despite offering a lower rate of return than
other assets, it may help to note evidence that fiat money
and capital are held for different motives. Fiat money
changes hands much more frequently than other assets(is held for
shorter periods of time) and (with other money-like assets) is
used in the bulk of all transactions. Money’s acceptance,
despite its low rate of return, may therefore be linked to
its usefulness in exchange.
Whenever an exchange takes place, there may be “transaction
costs”incurred that would not have been incurred if the owners
had held simply onto the items exchanged. It is generally
accepted that money is less costly to exchange than other
assets. A person can exchange $10 worth of currency for $10
worth of the consumption good in the blink of an eye.
There is virtually no transaction cost associated with exchanging
dollars, for example, for goods. In contrast, suppose you
wanted to exchange a housefor consumption goods today.The cost
incurred when a housechanges hands is compared with the
negligible cost of exchanging fiat money. It costs thousands of
dollars to verify the quality of the houseand that ownership
is legal. To make a housesell quickly, a person will need to
drop the price so that the house’s price and its value – what
it would sell for in a reasonable amount of time – can
be substantially different. We call the drop in price relative
to value and the other selling costs a transaction cost. For a
house, the transaction cost can be much greater if you have
CHAP 8 Modeling Monetary Economies
4th Edition
MONEY AND BANKING
, lOMoAR cPSD| 45211451
Chapter 8
Liquidityand Financial Intermediation
1 Roadmap
In Chapter 7, started with new storesof value that were
perfect substitutes for fiat money. In these economies, we learned
that if the rate of return on other assetsis greater than
that of fiat money, fiat money will not be valued. Yet,
when you look around, you see that fiat money is valued
in many real economies even though other assets, like capital, have
a greater return than fiat money. One way to get
money and capital to coexist is to assume the return
on capital is riskier than the return on money.
Here, we consider the additional possibility that fiat money is
valued because it is more liquid than alternative assets.
To incorporate liquidity into the basic framework, we add an extra
period to a person’s life. With three-period-lived people, liquidity
is easy to characterize: a store of value is more liquid if
it can be turned into the consumption good at any time
in a person’s life at the lowest cost. After presenting a
model economy in which liquidity differences exist, we talk
about banks as a means of overcoming liquidity problems. A
bank, or any financial intermediary, is a private company
that can arrange to offer peoplea liquid substitute for fiat
money. Why might it wish to do so? The difference in the rate
of return of liquid and illiquid assetsopensup an
opportunity for profits through arbitrage – by borrowing at the
low rate of return of money while investing at the high rate
of return of the illiquid asset.
As we develop these topics, there is an important friction
that keeps people from doing a bank’s jobs on their own.
Specifically, we do not allow people to create their own
, lOMoAR cPSD| 45211451
paper claims that would allow them to effectively sell part of
their capital. The information problem arises because it is
assumed to be too costly for anyone to verify that such a
claim is valid or not.
2 Money as a Liquid Asset
As we saw in Chapter 7, if fiat money and other
assetswere perfect substitutes, people would value only the asset with
the greater rate of return. To explain why fiat money
is valued despite offering a lower rate of return than
other assets, it may help to note evidence that fiat money
and capital are held for different motives. Fiat money
changes hands much more frequently than other assets(is held for
shorter periods of time) and (with other money-like assets) is
used in the bulk of all transactions. Money’s acceptance,
despite its low rate of return, may therefore be linked to
its usefulness in exchange.
Whenever an exchange takes place, there may be “transaction
costs”incurred that would not have been incurred if the owners
had held simply onto the items exchanged. It is generally
accepted that money is less costly to exchange than other
assets. A person can exchange $10 worth of currency for $10
worth of the consumption good in the blink of an eye.
There is virtually no transaction cost associated with exchanging
dollars, for example, for goods. In contrast, suppose you
wanted to exchange a housefor consumption goods today.The cost
incurred when a housechanges hands is compared with the
negligible cost of exchanging fiat money. It costs thousands of
dollars to verify the quality of the houseand that ownership
is legal. To make a housesell quickly, a person will need to
drop the price so that the house’s price and its value – what
it would sell for in a reasonable amount of time – can
be substantially different. We call the drop in price relative
to value and the other selling costs a transaction cost. For a
house, the transaction cost can be much greater if you have
