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Liquidity, Money Creation And Destruction, And The Returns To Banking

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  • Ricardo de O. Cavalcanti
  • Andrés Erosa
  • Ted Temzelides

Abstract

We build on our earlier model of money in which bank liabilities circulate as a medium of exchange. We investigate optimal bank behavior and the resulting provision of liquidity under a range of central bank regulations. In our model, banks issue inside money under fractional reserves, facing the possibility of excess redemptions. Banks consider the float resulting from money creation and make reserve-management decisions that affect aggregate liquidity conditions. Numerical examples demonstrate positive bank failure rates when returns to banking are low. Central bank interventions may improve banks' returns and welfare through a reduction in bank failure. Copyright 2005 by the Economics Department Of The University Of Pennsylvania And Osaka University Institute Of Social And Economic Research Association.

Suggested Citation

  • Ricardo de O. Cavalcanti & Andrés Erosa & Ted Temzelides, 2005. "Liquidity, Money Creation And Destruction, And The Returns To Banking," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 675-706, May.
    • Handle: RePEc:ier:iecrev:v:46:y:2005:i:2:p:675-706
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    References listed on IDEAS

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    1. Ricardo de O. Cavalcanti & Andres Erosa & Ted Temzelides, 1999. "Private Money and Reserve Management in a Random-Matching Model," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 929-945, October.
    2. Cavalcanti, Ricardo de Oliveira & Forno, Henrique Dezemone, 2004. "Money with Bank Networks," FGV EPGE Economics Working Papers (Ensaios Economicos da EPGE) 545, EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil).
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    4. Ricardo de O. Cavalcanti & Neil Wallace, 1999. "A model of private bank-note issue," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(1), pages 104-136, January.
    5. Cavalcanti, Ricardo de Oliveira & Forno, Henrique Dezemone, 2004. "Cyclical Interest Payments on Inside Money," Economics Working Papers (Ensaios Economicos da EPGE) 546, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
    6. Mills, David C., 2007. "A Model In Which Outside And Inside Money Are Essential," Macroeconomic Dynamics, Cambridge University Press, vol. 11(3), pages 347-366, June.
    7. Cavalcanti, Ricardo de O & Wallace, Neil, 1999. "Inside and Outside Money as Alternative Media of Exchange," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 443-457, August.
    8. Ricardo O. Cavalcanti, 2004. "A monetary mechanism for sharing capital: Diamond and Dybvig meet Kiyotaki and Wright," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 24(4), pages 769-788, November.
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    11. Ping He & Lixin Huang & Randall Wright, 2005. "Money And Banking In Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 637-670, May.
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    Cited by:

    1. Thorsten Koeppl & Cyril Monnet & Ted Temzelides, 2005. "Mechanism Design and Payments," 2005 Meeting Papers 11, Society for Economic Dynamics.
    2. Fernández-Villaverde, Jesús & Sanches, Daniel, 2019. "Can currency competition work?," Journal of Monetary Economics, Elsevier, vol. 106(C), pages 1-15.
    3. Andolfatto, David & Nosal, Ed, 2009. "Money, intermediation, and banking," Journal of Monetary Economics, Elsevier, vol. 56(3), pages 289-294, April.
    4. Daniel Sanches, 2016. "On The Welfare Properties Of Fractional Reserve Banking," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 57(3), pages 935-954, August.
    5. Daniel R. Sanches, 2013. "Banking crises and the role of bank coalitions," Working Papers 13-28, Federal Reserve Bank of Philadelphia.
    6. Allen Head & Junfeng Qiu, 2007. "Elastic Money, Inflation, And Interest Rate Policy," Working Paper 1152, Economics Department, Queen's University.
    7. Daniel R. Sanches, 2013. "On the welfare properties of fractional reserve banking," Working Papers 13-32, Federal Reserve Bank of Philadelphia.
    8. He, Ping & Huang, Lixin & Wright, Randall, 2008. "Money, banking, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 55(6), pages 1013-1024, September.
    9. Chen, Siyan & Wang, Yougui & Li, Keqiang & Wu, Jinshan, 2014. "Money creation process in a random redistribution model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 394(C), pages 217-225.
    10. Ricardo Lagos & Guillaume Rocheteau & Randall Wright, 2017. "Liquidity: A New Monetarist Perspective," Journal of Economic Literature, American Economic Association, vol. 55(2), pages 371-440, June.
    11. Daniel Sanches, 2016. "On The Welfare Properties Of Fractional Reserve Banking," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 57, pages 935-954, August.
    12. Ricardo de O. Cavalcanti, 2010. "Inside-money theory after Diamond and Dybvig," Economic Quarterly, Federal Reserve Bank of Richmond, vol. 96(1Q), pages 59-82.

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    More about this item

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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