Money is Debt

Carolyn Sissoko*
May 9, 2016

Abstract: This paper uses a new monetarist framework to present and explain the basic elements of a
non-monetarist theory of money, classical banking theory, by modeling acceptance banking, the form of
banking that was dominant during the 19th century when the theory was developed. The most important
principle of classical banking theory is that the money supply must be able to expand to meet
unpredictable “needs of trade.” Underlying this approach is the view that the optimal quantity of money is
inherently stochastic due to real productivity shocks that are constantly changing the optimal level of
economic activity.
The basic premise of classical banking theory is that transactions are typically paid for by incurring debt,
and that the role of the banking system is the monetization of this transaction-based debt. In this
framework bank liabilities are the principal form of money, and they circulate because they are backed by
debt that can be repaid by depositing bank liabilities into one’s account. When fiat money is introduced
into the model we find that non-banks are willing to carry fiat money from one period to the next because
it is a non-interest-bearing asset and reduces the costs of borrowing to transact.
The paper also explains how the model can be reinterpreted as a model of the modern banking system.

                                                            
*
Many thanks go to Randy Wright who encouraged to sit down and write this paper and gave me invaluable
comments, and to David Andolfatto and Charles Goodhart for excellent comments. All errors are, of course, my
own.
Author email: csissoko5@gmail.com

 
 
This paper uses the new monetarist framework to present and explain the basic elements of a non-
monetarist theory of money, classical banking theory. Classical banking theory developed over the course
of the 19th century in Britain and is closely tied to developments in the monetary system of that era. To
those trained in Keynesian or Neo-classical economics, classical banking theory takes a very
counterintuitive approach to money: bank liabilities are the primary form of money; fiat money exists to
provide support to the banking system in crisis; and banks are money dealers – their business is to
exchange debt that circulates as money for debt that does not.1
The most important principle of classical banking theory is that the money supply must be able to expand
to meet unpredictable “needs of trade.” 2 Underlying this approach is the view that the optimal quantity of
money is inherently stochastic due to real productivity shocks that are constantly changing the optimal
level of economic activity. Classical banking theory treats the banking system as the mechanism by which
the money supply expands and contracts on an “as needed” basis. This paper models the 19th century
monetary system in Britain as a money supply backed by unsecured debt, and shows how in an
environment with productivity shocks such a monetary system adjusts to the needs of trade. The paper
finds that this system provides the optimal quantity of money only if enforcement is exogenous; with
endogenous enforcement the provision of bank services is incentive compatible only due to a positive
lending rate that has the effect of taxing consumption.
The paper then extends the model to incorporate fiat money that circulates alongside bank liabilities. We
find, first, that in an environment where debt is the principal means of exchange, the return on fiat money
is given by the interest that is saved when the issue of debt is reduced. Second, this model provides a
counter-example to Gu, Mattesini, and Wright (2014)’s claim that when credit is easy, money is useless,
and when money is essential, credit is irrelevant. Here, the “needs of trade” are met by credit, but the
introduction of fiat money may be welfare improving, because introducing central bank control of the
supply of fiat money makes possible a decline in the interest paid on debt.
Finally the paper uses the model to explain how regulatory arbitrage motivated the metamorphosis of the
19th century banking system into the modern deposit-based banking system. This allows the model to be
reinterpreted as a model of the modern banking system.
The new monetarist framework is well-suited to the study of classical banking theory, because both
approaches are motivated by the same frictions: liquidity frictions which ensure that there is a role for a
means of exchange since agents buy and sell at different points in time, and limited commitment which
restricts the use of bilateral credit as a means of exchange. Classical banking theory supports, however, a
research agenda that is somewhat different from the one that new monetarists are currently exploring. In
particular, it indicates that a much more detailed study of the nature of limited commitment – and of how
banking functions as a mechanism that mitigates commitment problems – is necessary.3

                                                            
1
Classical banking theory was the dominant approach to money at the turn of the 20th c. See e.g. Bertil Ohlin’s
introduction to Wicksell’s Interest and Prices (at vii, R.F. Kahn transl., 1898). See also Dunbar (1909) 13-14, 18;
Willis, American Banking 3-4 (1916); John Stuart Gladstone Wilson, Encyclopedia Britannica, “Bank.” The term
“money dealer” is used by Perry Mehrling (2012), who has developed a balance sheet framework for analyzing
money and banking.
2
See Wicksell (1898) at 110.
3
For example, Wicksell did not just present a “pure credit” model of the economy, but also argued that innovations
in banking were making “perfect mobility of money” possible: “The various practical obstacles which stand in the
way of ideally perfect mobility of money are gradually being removed as a result of concentration in the hands of
the banks of cash holdings and of the business of lending, and of the use of bills and notes, cheques and clearing

1 
 
Even though new monetarism has progressed far beyond the original framework established by Milton
Friedman, research in this area is still limited by the assumptions upon which “old” monetarism was
founded. Friedman emphasized the importance of fiat money, or an asset that both circulates and pays no
nominal return, as the primary means of exchange and viewed credit as both supplementary and
subordinate to fiat money. In particular, monetary policy could be used to control both the quantity of fiat
money and the monetary forms of credit that derived from it. Similarly, much of the new monetarist
literature focuses on fiat money not banking (see, e.g., Nosal and Rocheteau (2011) which does not
devote a single chapter to banking).4
Because the new monetarist literature grows out of the older monetarist tradition, many new monetarist
models view money as “an object that does not enter utility or production functions, and is available in
fixed supply” (Kocherlakota 1998) and treat the quantity of fiat money as a key policy variable. Classical
banking theory, by contrast, takes a very different approach to the question “What is money?” Bank
liabilities are viewed as the primary means of exchange and fiat money as subordinate;5 furthermore, non-
banks borrow from banks in order to obtain bank liabilities, so the whole of the payment system is based
on credit. In other words, banks are money dealers so that each non-bank in the economy is typically both
a borrower from a bank and the creditor of a bank, often simultaneously.
Not only does classical banking theory answer the question “What is money?” differently, it also has a
very different answer to the question “What is banking?” For example, when banking is studied using the
new monetarist framework, one of two approaches is typically taken: either banks are modeled as a
Diamond-Dybvig’s mutual-fund-like intermediaries that receives deposits of real goods and then invest
those goods on behalf of their depositors or note-holders (see, e.g., Gu, Mattesini, Monnet, and Wright
(2013); Sanches (2015)) or banks are agents with superior commitment ability who issue inside money
(see, e.g. Cavalcanti and Wallace 1999a,b). Classical banking theorists view the key banking activity not
as the investment of deposits, but as the exchange of two types of debt: for a fee a bank is willing to allow
a buyer to trade using the bank’s liability, and accepts in exchange the liability of the buyer to the bank.
The key distinction from the standard approaches is that debt sits not only on the liability, but also on the
asset side of a bank balance sheet. While it is true that the banker receives payment from the buyer,
because the banker has superior commitment ability and a banker’s debt is accepted as a means of
payment in circumstances when the buyer’s debt is not, an essential role played by the banking system is
to manage the incentives faced by those who use bank services and engage to pay for those services with
their own liabilities.
To relate classical banking theory to the new monetarist framework, several fundamental changes are
required. First, the new monetarist framework is designed to answer the question: “When is money
essential in an economy?” Because classical banking theory treats bank liabilities as the primary means of
exchange, this question is interpreted as “When do bank liabilities, D, play an essential role in an
economy?” To introduce M, fiat money, into the economy, one must then define M’s relationship to D.

                                                            
methods. Money is continually becoming more fluid, and the supply of money is more and more inclined to
accommodate itself to the level of demand.” Knut Wicksell, Interest and Prices 110 (R.F. Kahn transl., 1898).
4
Examples of models with banking include: Cavalcanti and Wallace (1999), Gu, Mattesini, Monnet, and Wright
(2013); Sanches (2015). But see Berentsen, Camera, Waller (2007), discussed below, for a paper that begins to
explore some of these issues.
5
See, e.g., Ralph Hawtrey, Currency and Credit 185 ff. (1919). In classical banking theory fiat money (in the form
of central bank notes) serves (i) as the means of payment that banks use to clear their own debts and (ii) as a form of
money that can expand to support the banking system through a crisis of confidence.

2 
 
Next, classical banking theory developed in a world where acceptance (or discount) banking was the
norm. Thus, the bank liabilities studied initially in this paper are not deposits, but accepted bills. The key
difference is that under the acceptance system, a potential bank client would not bring a deposit to a bank,
but would instead apply for a credit line. After the application was approved the client could write a bill
(an IOU comparable to a post-dated check) drawn on the bank, and after the bank “accepted” the bill as
its own liability, the accepted bill circulated easily in the money market. In short, classical banking theory
assumes that discounts (or negative bank accounts) are as common as deposit accounts. Thus, in this
model bank liabilities take the form of accepted bills.
It is crucial to observe three characteristics of this framework: First, the proto-typical bank client under
acceptance banking does not offer anything that can be used as collateral to the bank. The credit line
offered by the bank to the non-bank is based on unsecured debt, or in other words, on an incentive
constraint.6 Second, acceptances are contingent liabilities for the banks and therefore off balance sheet.
Because the banks are simply putting their own guarantees on the debt of non-banks, the banks
themselves are not constrained by any requirement that there must be an inflow of deposits in order for
guarantees that function as loans to be made. Third, the credit line offered by the non-banks, when they
accept bank liabilities as money, to the banks is also based on unsecured debt and an incentive constraint.
In short, the model of money presented by classical banking theorists is based on two incentive
compatibility constraints, one for the non-banks and one for the banks, and these are the only limitations
on the capacity for the money supply to expand.
In this environment interest rates play a very different role compared with most of the existing literature.
Because the existing literature assumes that deposits must fund loans, this literature uses the interest rate
as the price at which borrowing markets clear. Here the quantity of loans is bounded by the two incentive
constraints which will ensure that no agent wishes borrow more than that agent can repay. In this
environment a range of interest rates is consistent with equilibrium. If rates are too high borrowers will
not want to borrow, and if rates are too low banks would prefer the one time payoff that can be gained by
using money supply expansion to fund bank consumption to the continuation value of banking. In order to
fix the interest rate in our model, we assume that the central bank sets a minimum rate and that Bertrand
competition between the banks ensures that this minimum rate is also the rate offered by the banks.
Finally, classical banking theory is distinguished from the new monetarist view, because the quantity of
money is determined by the “needs of trade.” To be more precise, bank liabilities are put into circulation
by lending to the public, and thus it is only to the degree that the public has a demand for loans from
banks that the stock of bank liabilities can increase. In the model developed below, D, expands as the
banking system makes loans to late producers, and contracts when those loans are paid off.
As will be shown below, when bank liabilities are put into circulation by lending to the public this fact
then motivates the circulation of the liabilities in a way that is perfectly analogous to the legal tender
theory of money: buyers know that the accepted bills that they receive in payment today will have value
tomorrow, because the borrowers need to hold accepted bills at the end of day tomorrow in order to settle
their debts. Thus, as long as borrowers are properly incentivized to repay their debts, it is the fact that
bank liabilities are backed by debt that gives them value tomorrow. And indeed in Anglo-American
economies banking developed in an environment where alternative means of settlement, such as gold coin

                                                            
6
A seminal paper in the study of unsecured debt is Timothy Kehoe & David Levine, Debt-Constrained Asset
Markets, 60 Rev. Econ. Stud. 865 (1993).

3 
 
or central bank notes, were sufficiently scarce that bank liabilities were as a practical matter the means of
settlement.
When we introduce fiat money into this model, we find that non-banks are willing to carry fiat money
from one period to the next because it is non-interest-bearing asset and thus allows the non-banks to
conserve on the interest costs of borrowing to transact. We also find that the introduction of fiat money is
welfare-improving in comparison with the environment where bank liabilities are convertible into the
numeraire good: when bank liabilities are denominated in fiat money, the ability of the monetary
authorities to control the growth rate of the fiat money supply allows bank intermediation to be incentive
compatible at a lower cost to non-banks. In this environment the Friedman Rule is not optimal – it will
instead result in the complete breakdown of financial intermediation.
The literature: Motivating literature from the early 20th century
To motivate the very different approach to money and banking taken in this paper, I argue that one cannot
read and understand monetary economists who were writing in the early decades of the 20th century such
as Knut Wicksell and Joseph Schumpeter unless one understands that the model of money upon which
their work was based was one where the size of the money supply was a function of unsecured, incentive-
based bank lending.7 That is, they did not view the constraints on banks’ ability to expand the money
supply as determined by quantities such as the quantity of deposits or the quantity of central bank
reserves, but they viewed these constraints as determined by the public’s willingness to hold bank
liabilities. In the modern literature such constraints are represented by incentive compatibility constraints.
Indeed, the logic of incentive compatibility constraints explains one of the basic principles of early bank
supervision: the importance of franchise value. In particular, the archetypical incentive compatibility
constraint for debt is:

where β is the discount rate, V is the continuation value of not defaulting, Vd is the continuation value of
default, is the one-period utility of default, and u is current period utility in the absence of
default. is the maximum amount that banks can borrow, and is strictly increasing in . Thus,
incentive compatibility analysis tells us that the maximum liquidity that can be provided by the banking
system, or in other words the maximum size of the money supply, , depends on the degree to which
banks value the future, β, on the banks’ franchise value, V, and on the severity of the punishment that will
be imposed on banks which fail to honor their debt, Vd.
The basic structure of early bank supervision took the following form: any banker who defaulted was
forced into bankruptcy and excluded from the banking industry. Because the franchise value of banking
was very high relative to other professions exclusion from the industry was a serious penalty.8 Indeed, as
recently as the last decade of the 20th century U.S. regulators argued that the franchise value of banking
played an important role in the stability of the banking system (Demsetz et al. 1996). In short, incentive
constraints were understood to play an important role in banking, and there was a healthy skepticism
towards competition that could have the effect of eroding the franchise value.

                                                            
7
Indeed, Wicksell’s argument in Interest and Prices is actually that the channel through which interest rates affect
prices is through banks’ credit policy. Wicksell at 80. See also pp. 104 -06 and 135.
8
Note that, while banking developed in an environment where loss of a banker’s personal wealth played an
important role in the default penalty, by the 20th century corporate banking had become the norm, rendering loss of
franchise value a more important penalty.

4 
 
The literature: Modern building blocks
This paper builds on the model developed in Berentsen, Camera, & Waller (2007). As in that paper banks
will function as the record-keepers of non-bank financial histories, and we will explore how the money
supply can expand with the needs of trade in an environment where non-banks who are anonymous with
respect to each other can choose to use the banking system to establish a financial history and thus to be
non-anonymous with respect to the banks. On the other hand, unlike BCW in this model bank liabilities
also circulate as a means of exchange, and thus banks are also characterized by having public histories:
any bank that ends a period with more liabilities than assets is forced into bankruptcy and out of banking.
This structure builds on Gu, Mattesini, Monnet, and Wright (2013) which establishes that such
“visibility” is one of the characteristics that makes an agent “better suited” to banking and on Cavalcanti
and Wallace (1999a,b) which explores the implications of public histories in an environment where banks
issue notes.
In BCW the gain from financial intermediation is due to the fact that it allows interest to be paid to
depositors and does not arise due to the relaxation of borrowers’ liquidity constraints. The model here
presents a very different form of monetized credit, where the gain from financial intermediation does arise
due to the relaxation of liquidity constraints. To emphasize this point, we focus on an environment where
no interest is paid to the non-bank lenders, who play the same role in our model as BCW’s depositors.
Gu, Mattesini, and Wright (2014) study the relationship between money and credit, and find that
environments where the introduction of money increases the welfare attainable within the set of incentive-
feasible allocations always have the characteristic that credit is constrained. This paper presents a counter-
example where credit constraints don’t bind, but the introduction of fiat money – or more precisely the
denomination of credit in fiat money and the introduction of fiat money supply growth as a control
variable – can improve the set of incentive-feasible outcomes.
Monnet and Sanches (2015) explore the nature of franchise value in a model where banks issue bank
notes. They find results with respect to franchise value that correspond closely to those found in this
paper: because competitive banking erodes franchise value, it can only support a very inferior equilibrium
in terms of welfare; only in environments where the returns to banking are supported by constraints on
competition can there be a high welfare equilibrium. Martin and Schreft (2005) find a similar result: the
laissez faire result when banking is competitive can always be improved upon by the introduction of a
regulating institution. This paper is distinguished from Monnet Sanches and Martin Shreft because it
studies a different form of banking, acceptance banking.
Section I introduces the model of bank acceptances. Section II describes the equilibria of this model.
Section III introduces fiat money into the model. Section IV explains how the modern banking system, in
which deposits are an important component of the money supply, evolved due to regulatory arbitrage out
of the acceptance banking system. Section V concludes.
I. Commercial bills: a means of payment that expands with the needs of trade

Time is discrete, indexed by t = 0, 1, 2, . . ., and extends over an infinite horizon. Following Berentsen,
Camera, and Waller (2007) (BCW) in each period two perfectly competitive markets open sequentially.
There are two consumption goods, x, which is perishable and must be consumed during the first market
(FM) and X, which is perishable and must be consumed during the second market. The second market
will be abbreviated CM, because this market plays the same role as the centralized market in the Lagos-
Wright (2005) framework upon which BCW is built.

5 
 
There is no discounting between the FM and the CM. The discount factor from one period to the next is
given by β.
There are two types of agents, non-banks and banks, and there is a continuum of mass one of each type of
agent. Non-banks experience a preference shock at the beginning of each period such that with probability
n the agent is an “early producer” and with probability 1 – n the agent is a “late producer.” Early
producers can only produce in the FM at cost c(q) = q2/2A where q is the amount produced of good x and
A is a production shock. The production shock takes one of two values ∈ , with
and 1 . In the CM early producers can only consume, deriving utility U(X) = X. Late
producers can only consume in the FM, deriving utility u(x) = xα where ∈ 0,1 . In the CM late
producers produce at cost C(Q) = Q, where Q is the quantity of good X produced. Banks do not produce
and consume only in the CM, deriving utility U(X) = X.
Both forms of uncertainty, the preference shock and the production shock, are realized at the start of each
period. These shocks are publicly observable.
As in BCW, we assume that the goods trades that take place in the FM and the CM are anonymous, that
agents cannot identify their trading partners, and that trading histories are private information. A late
producer cannot commit to paying an early producer in the future, because he will not be able to meet and
identify the right early producer. Thus, in the absence of some kind of a monetary device, anonymity will
force the economy to be autarkic in the FM.
Banks have a technology that makes it possible for them to record the financial history (but not the
trading history) of each member of the economy. The account-keeping technology is operated costlessly.
Banks also have a public history: if at the close of the period interbank clearing leaves a bank with a
negative net worth, then the bank is forced to declare bankruptcy publicly.
Acceptance banking

Banks offer credit lines to late producers up to a limit, ℓ, which is endogenous and ensures that repayment
of debt is incentive compatible for the late producer. A late producer draws down on the credit line by
issuing a bill that is instantaneously accepted by the late producer’s bank. This has two effects: it converts
the bill into an accepted bill that is a liability of the bank similar to a bank note and it draws down the
credit line that the bank has extended to the late producer. Commercial bills are modeled here as bearer
bills, and are payable to whoever holds them.
Thus, in an acceptance banking system there are two distinct ways in which commercial bills function as
money. First, commercial bills are loans that draw down the credit line that a bank has extended to the
issuer. Second, because an accepted commercial bill is a bank liability, third parties are willing to receive
it in payment and it circulates as money. Thus, the physical document that is an accepted commercial bill
is simultaneously both a bank loan and a bank note.
The distinguishing characteristic of an accepted bill is that there are two parties who are both fully liable
for payment of the bill, the non-bank issuer and the bank-acceptor. The liability to the bank of the issuer
of the commercial bill is extinguished when the issuer deposits accepted bills equal in value to his debt in
his account. A bank’s liability on an accepted bill is extinguished when the accepted bill is deposited into

6 
 
a bank account and thus it no longer circulates. The details of how the banks operate a clearing and
settlement system are omitted from the model.9
Banks also have the technology to circulate their bills in the CM in order to purchase the consumption
good. Such a circulation of bills is, however, inherently fraudulent, because in this model there is no way
for such bills to be paid and their issue guarantees that the issuing bank will be bankrupt at the end of the
period. Since the banks have the technology to profit from such a default, the banks face an endogenous
limit on their liabilities, . At the end of a period in which a bank fraudulently circulates bills, the bank
will be bankrupt and be forced into autarky. This technology is only available to a bank that was active in
lending in the FM – a restriction that can be viewed as an aspect of the bank’s public history.
In this model banks offer loans that extend from the FM to the CM of a given period. Observe that even
after a loan is paid off by its issuer (who has deposited funds to cover the bill he has drawn on his
account), the accepted bill that created the loan may continue to circulate as a bank liability until such
time as the holder of the accepted bill chooses to present it to a bank.
After the realization of the uncertainty at the start of the FM, trade in the first market takes place and late
producers issue bills that draw down their bank credit lines. Such loans are denoted by ℓ ∈ [0, ℓ], and the
interest rate, i ≥ 0, is charged on the loan and payable in the CM along with the principal of the loan. The
punishment for a default on a loan is loss of access to bank services in the future. Let d ∈ [0, ∞) represent
physical holdings of accepted bills.
The First-Best Allocation: To find the first best allocation we assume that all agents are treated
symmetrically. The problem is the same in each period except for the production shock. We consider the
first-best allocation to be the allocation that a social planner would choose in each period if she could
allocate consumption after learning the outcome of the production shock.
After the realization of the production shock, but before the realization of the preference shock, in each
period a representative agent has the expected utility:

1 (1)
2
And optimization will be subject to the FM and CM feasibility constraints:
1 (2a)
1 (2b)

The first order conditions of this problem indicate that optimal FM consumption is:

∗∗
1
optimal FM production is:
∗∗
1 ∗∗

and that all values that satisfy the CM feasibility constraint will be optimal. Thus, the quantities that a
social planner who could force agents to produce and consume would choose in each period are given by
x**(A) and the feasibility constraints.

                                                            
9
The focus on symmetric equilibria and banks that are in all respects identical means that this amounts to
unnecessary detail here.

7 
 
 II. Symmetric equilibrium

Following BCW, we limit our attention to stationary symmetric equilibria where each type of agent plays
the same pure strategy and where the real value of the accepted bills that are carried from one period to
the next is constant. We first analyze the choices made by an early producer in the second market, then in
the first market, and then we analyze the late producer’s choices. Only after optimizing choices in each of
the markets have been established do we fully specify all of the relevant value functions.
To simplify notation, current period variables will be denoted without a subscript, next period variables
with prime mark and previous period variables with the subscript -1.
The Early Producer’s Problem: Observe that an early producer – who does not intend to default – derives
only costs and no benefits from borrowing. For this reason, banks will not extend loans to early
producers. Then, letting Wep(d) represent the value to an early producer of entering the CM with accepted
bills, d, and V(d’) represent the value to a non-bank of starting the next period with accepted bills, d’, we
find:
max , (3)
subject to the budget constraint

where ϕ is the value of an accepted bill in terms of good X in the CM. The early producer maximizes
consumption in the CM and the discounted value of carrying d’ into the next period FM subject to the
constraint that value of the accepted bills carried into the CM must equal the CM goods consumed and the
value of the accepted bills carried into the next period. Substituting out for X, we find:
max
0
The first order condition for the choice of d’ is:
′ (4)
with complementary slackness. Thus, this choice does not depend on the quantity of accepted bills
brought into the CM. All early producers will carry the same quantity of accepted bills into the next
period.
Observe that the envelop condition for this problem is:

Now consider the FM and the problem faced by an early producer who brings bills, d, into the FM. After
the realization of uncertainty at the start of the FM the early producer’s problem is:
1
max
2
where p is the price of the good in the FM market. That is, the early producer chooses q to maximize the
sum of the costs incurred by producing q and the value to the early producer of carrying the proceeds of
the sale of q into the CM. The first order condition for this problem is
/ 0
and an optimizing early producer will choose
∗
, (5)
Observe that the amount that early producers choose to produce does not depend on the quantity of bills
that they bring into the market, but only on the value of the product and their productivity this period.

8 
 
The Late Producer’s Problem: Turning to the late producer, observe that the late producer’s value
function in the CM depends on loans as well as accepted bills brought into the CM:
ℓ, max ,
subject to the budget constraint
1 ℓ
The late producer maximizes the sum of the cost of producing in the CM and the continuation value of
carrying d’ bills into the next period subject to the constraint that the value of the bills carried on must
equal the quantity produced plus the value of bills less the expense to the late producer of paying off the
loan. Observe that this expense has two components: the principal of the loan which is paid off by
producing in exchange for acceptances that will be deposited in the issuer’s account and the interest on
the loan which may be paid by transferring real goods to the bank.
Just as in the case of the early producer, this problem can be rewritten:
ℓ, 1 ℓ max
1 ℓ 0,0
And we find that once again the assets that are brought into the CM do not affect the choice of bills
brought out of the CM. As a result both early producers and late producers solve the same problem in the
CM, have the same first order condition, and will carry the same quantity of bills into the next period.
The envelop conditions for the late producer are:
ℓ 1

These conditions determine the optimizing choices that a late producer will make when transacting with a
bank in the FM. When a late producer brings accepted bills into the FM, the fact that i ≥ 0 ensures that the
late producer will prefer to spend the bills that were brought into the FM rather than holding them and
taking out a loan to make up the difference.
Thus, after the realization of the uncertainty at the start of the FM, there are two cases that must be
addressed for the late producers’ problem: the case in which the late producer holds enough bills to
purchase the desired quantity of goods given the price, and the case in which the late producer must
borrow to purchase the desired quantity of goods.
Case 1: When the realization of A is such that the late producer holds enough bills to purchase the goods
given the price, the late producer’s problem is:
max 0,
The late producer maximizes the sum of the utility he receives from consumption and the continuation
value of reducing the bills carried in the CM by the cost of purchasing the consumption goods. The first
order condition for this problem is:
0
and we find that the optimal choice of x for a late producer will be / .
Case 2: When the late producer’s stock of bills is insufficient to purchase the desired quantity and the late
producer must take out a loan, the late producer’s problem is:
max ,0
subject to
ℓ
where ℓ is a borrowing constraint that is taken as given by the late producers. That is the late producer

9 
 
maximizes the sum of his current period utility from consumption and the continuation value of spending
all of his bills and carrying a loan in to the CM, subject to the constraint imposed by the bank on the size
of the loan. The first order condition is then:
ℓ 0
where λ is the multiplier on the borrowing constraint. When the borrowing constraint doesn’t bind and
λ = 0, we find that the late producer’s optimal choice will be / 1 . When the constraint does
bind, the late producer’s optimal choice will be ℓ / .
FM Market Clearing: We know that all non-banks will bring the same quantity of bills into the FM, and
the focus of our analysis is on symmetric equilibria in which all agents who face the same problem, take
the same, pure strategy action. Thus, by substituting the optimal choices of x and q into the FM feasibility
constraint, equation (2a), we can solve for the market clearing price as a function of A in each case

1 1
(6a)

1 1
(6b)
1

1 ℓ
ℓ (6c)

where the subscripts, j = 1, 2, and 2ℓ, index the no borrowing, unconstrained borrowing and constrained
borrowing cases respectively. Then expenditure on the FM good given A is:
1
0 in the case of no borrowing

1
in the case of unconstrained borrowing

ℓ in the case of constrained borrowing

where
1
≡
1

Observe that for a given value of A, when i > 0, π(i) < π(0), and that in this case there will always exist
some real quantities of acceptances, ϕd, for which 0 . This circumstance cannot
be part of an equilibrium, because the assumption about borrowing on the basis of which expenditure was
derived is violated.10 This intuition underlies Lemma 1.

                                                            
10
Note that it may be possible to establish that there is a mixed strategy equilibrium in which agents randomize
between borrowing and not borrowing, but in this paper the focus is on pure strategy equilibria, so we do not explore
the existence of mixed strategy equilibria.

10 
 
Lemma 1: Steady state levels of real acceptances, ϕd, must lie within 0, or 0 , ∞ or

0 , . In the first case, agents always borrow, in the second case, agents never borrow,
and in the third case – if the set is not empty – agents borrow only when the realization of the productivity
shock is high.

Proof: Observe that and 0 0 and that, when i > 0, π(i) < π(0), so
0 . Thus there are two cases to consider:

Case 1: 0 0 and

Case 2: 0 0

When ϕd lies either between and 0 or between and 0 , the agent holds
too many accepted bills for borrowing to be an equilibrium and too few accepted bills for not borrowing
to be an equilibrium. Thus, when ϕd lies between these two regions, ϕd cannot be an equilibrium for one
of the realizations of A, and any equilibrium realization of ϕd must lie within 0, or

0 , ∞ or, if the set exists, 0 , .■

In Lemma 2 we establish the condition in which the borrowing constraint will bind.

Condition 1: ℓ .

Lemma 2: Given an equilibrium level of debt, , the equilibrium is not one in which ℓ is ever
binding, iff Condition 1 holds at debt level, .
Proof: Lemma 1 defines the three cases that must be considered.

For ϕd ≤ , late producers borrow. If condition 1 is true, then late producers can borrow enough to
consume their preferred bundle for all realizations of A and ℓ does not bind. Similarly, if ℓ doesn’t bind
then it must be the case that late producers can afford their preferred bundle when is realized and that
Condition 1 is true.

For ϕd ≥ 0 , no borrowing takes place, so the question of ℓ being binding is irrelevant.

When ϕd lies between 0 and , if A is realized then ℓ will be irrelevant, and if is

realized, then Condition 1 remains the relevant condition. ■

11 
 
We conclude that the late producer’s demand function is given by:

if 0

. . if 0
, , ℓ, (7)
if ℓ
1
ℓ
otherwise

Observe also that when borrowing takes place unconstrained, a positive lending rate distorts consumption
relative to the first best allocation: because interest must be paid on the borrowed funds, late producers
will prefer to reduce consumption of the FM good relative to the first-best.
Banks:
Banks in our model set interest rates and credit limits, but otherwise respond passively to the economy’s
demand for accepted bills: they earn iϕL where L represents the aggregate quantity of loans. They are
willing to lend to each late producer whatever ℓ ℓ the late producer demands.
The first issue to address in a model in which banks “meet the needs of trade” by responding passively to
the demand for bank credit is how it is possible for a bank’s balance sheet to expand to meet the demand
for loans. This is explained by the fact that the accounting treatment for an accepted bill is typically “off-
balance-sheet.” That is, an accepted bill is a contingent bank liability that will only be payable if the
original issuer of the bill defaults. Accounting norms in general do not require that a contingent liability
be reported on balance sheet until it becomes probable that the contingency will be realized.11 For this
reason, there is no requirement in this model that the quantity of loans must be backed by “deposits.”
Table 1 uses T-accounts to depict first in Table 1a the standard view of banks as lending out deposits and
then in Table 1b the equivalent activity in terms of off-balance sheet banking. The key distinction is that
in the off balance sheet case, the loan is an on-balance-sheet liability only for a non-bank, and therefore
only the fee income that the bank derives from guaranteeing and thereby monetizing this loan shows up
on the bank balance sheet.
In Table 1a the “depositor” is the early producer who sells what she produces in the CM in exchange for
bank deposits. These show up as an asset on the early producer’s balance sheet and as a liability on the
bank’s balance sheet. In the meanwhile, the bank lends out these funds at interest to the late producer,
generating an asset comprised of the loan plus the interest receivable on it. The bank’s right to receive
interest is accounted for as bank equity. The loan, of course, also shows up as the late producer’s liability
– in exchange for which he consumed. In the CM the late producer produces and pays off the loan, and
the bank consumes the (equivalent of) the interest paid and pays off the deposit, which the early producer
uses to consume.

                                                            
11
For the off-balance-sheet treatment of accepted bills, see David Sheppard, The Growth and Role of U.K. Financial
Institutions 1880 – 1962 at 117 Table (A)1.1 n.4 (1971).

12 
 
 Table 1a: On Balance Sheet Banking
Late Producer Bank Early Producer
Asset Liab./Equity Asset Liab./Equity Asset Liab./Equity
(c) +ℓ(1+i) +ℓ(1+i) +d +d (π)
FM
Equity: +ℓi
(π) - ℓ(1+i) -ℓ -d -d (c)
CM
- ℓi (c)

Table 1b: Off Balance Sheet Banking

Late Producer Bank Early Producer
Asset Liab./Equity Asset Liab./Equity Asset Liab./Equity
(c) +ℓ(1+i) +ℓi Equity: +ℓi +d (π)
FM

(π) - ℓ(1+i) - ℓi (c) -d (c)

CM

Notes: Accounting rules imply that d == ℓ

(c) represents consumption
(π) represents production

In the off balance sheet case, Table 1b, the asset held by the early producer in the FM is an accepted bill
and the direct liability of the late producer. The bank’s role is to offer a guarantee that gives the accepted
bill value as a means of payment. In exchange for this service, the bank earns the right to the fee, ℓi. In the
CM the producer produces to pay off the accepted bill and the bank fee, allowing both the bank and the
early producer to consume.
It should be clear from these two tables that these are just two different ways for a bank to intermediate
the same real transactions.
While under modern accounting practices accepted bills are typically off balance sheet for a bank, an
alternate convention that was sometimes followed in the 19th century was to treat the accepted bills as
both an asset and a liability. Thus, we “stack the deck” against banking by taking the more conservative
view that accepted bills count against a bank’s debt limit. That is, even though the quantity of loans that a
bank can accept is not limited by the quantity of deposits placed with a bank, there is a limit on the
quantity of loans that a bank can accept. This limit is analogous to the borrowing limit that is faced by
non-banks: there is an endogenous debt limit, , that constrains the banks’ liabilities – and accepted bills
count against this constraint.
The banks’ debt limit is generated by the fact that banks have the technology to circulate bills that are not
related to non-bank transactions in the CM in order to purchase the consumption good. At the end of a
period in which a bank circulates such bills, the bank is bankrupt, is found out, and is forced into autarky.
In order for classical banking theory’s business of banking to be incentive compatible, it must be the case

13 
 
that banks will choose not to defraud the public by consuming as much as possible in the current period
and accepting the consequences of bankruptcy in the future.
Another issue arises in this framework: in an environment where banks respond passively to the
economy’s demand for bank-issued forms of money and where there is no fiat money, the time path of the
price of money will not be determined by monetary policy in the form of a money supply growth rate and
must therefore be determined by other means. Indeed, this basic corollary of classical banking theory and
the “needs of trade” approach to money has been recognized at least since Adam Smith.12
In this section of the paper, we will adopt the same convention that was common at the time that classical
banking theory was being developed – and that Adam Smith recognized as a solution to this problem: Just
as they did under the gold standard, banks in this model promise to convert bank liabilities during the CM
on a one for one basis into the numeraire good, X. Thus, not only is there no growth in the value of
money, but ϕ = 1 at all dates – as long as the promise made by the banks is credible:

1 (8)

Note, however, that in order to make clear the relationship with Section III in which fiat money is added
to the model and in order to keep track of when the promise made by the banks comes into play,
substitution for ϕ will be made only after equilibria have already been found.
We analyze two cases: enforcement equilibria where the debt of both non-banks and banks is
exogenously enforceable, and equilibria without enforcement in which lending constraints must be used
to guarantee the incentive compatibility of the repayment of debt.
Stationary enforcement equilibrium

In an enforcement equilibrium, because the debt of banks is exogenously enforceable, ∞, and,

because the debt of non-banks is exogenously enforceable, ℓ ∞. There are three possible types of
enforcement equilibria each of which is associated with a different value function. (The derivation of the
value functions is presented in Appendix 1.)

Case 1: , late producers always borrow

1 1 1
1 2 1
1 1 0 1 0, 0

Case 2: 0 , late producers never borrow

1 1 1 0 1 0, 0
2

Case 3: ∈ 0 , , late producers borrow only when is realized

                                                            
12
Adam Smith (1776) at II.2.96 – 97. See also Thomas Sargent & Neil Wallace, The Real Bills Doctrine vs. the
Quantity Theory: A Reconsideration, 90 J. Pol. Econ. 1212, 1213 (1982).

14 
 
 1 1 1 1
2 2 1 1
1 1 1 1 0 1 0, 0
In each case the value function depends on FM consumption, the value that the stock of accepted bills, d,
will make it possible to carry into the CM, and the continuation value of the game. Observe that FM
consumption is optimal when there is no borrowing and is reduced when late producers borrow and i > 0.
Observe also that in this environment where liquidity constraints don’t bind, the principal effect of d > 0
is not on FM consumption, but instead on the reduction of interest costs for borrowers. For this reason all
three value functions are linear in d and the solution to the optimization problem, equation (4), is well-
defined.
Intertemporal Optimization
Case 1: In this case consumption in the FM is independent of d, and the first order condition for the Case
1 value function is simply:
1

Thus, the only effect of an incremental increase in d, when , is to generate a return equal
to the value of carrying the bills into the next CM and the expected value of the interest avoided by late
producers.

Of course, in order for to be a stationary equilibrium it must be the case that an agent
optimizes in the CM, or that equation (4) is satisfied and therefore that the Case 1 agent prefers to spend
all but d of his deposits in the CM, or that
′ ′ ′ ′ 1 ′
or
⁄ ′
1 1 ′ (9)

When this equation holds as an inequality, d = 0 and an agent carries no bills from one period to the next.
This equation tells us that in order for no bills to be carried, it must be that the cost of carrying an
additional bill into the FM exceeds or equals the expected benefit that would result due to a decline in
borrowing. It incorporates the standard result that there is no monetary equilibrium if β > ϕ/ϕ’, since
agents would prefer to hold infinite quantities of acceptances. Recall, however, that in a classical banking
theory framework ϕ/ϕ’ = 1, and this condition would never occur.
Observe also that when agents choose not to carry bills from one period to the next, the Euler equation
defines the maximum steady state value of i that is consistent with this behavior, which we will denote ̂:
⁄
̂
1
Any steady state interest rate that exceeds ̂ will be inconsistent with optimization on the part of the non-
banks who borrow in each period.
Case 2: The Euler equation when late producers never borrow is:
⁄ ′
1 0
That is, in order for it to be optimal for late producers to never borrow, it must be the case that the

15 
 
Friedman Rule holds, or ⁄ ′ . Observe that convertibility of bank liabilities into the numeraire good
on a one to one basis guarantees that it will never be in the interests of non-banks to hold so many
accepted bills that they never borrow.

Case 3: The Euler equation when late producers borrow only if is realized is:
⁄ ′
1 1 ′

Banks: How interest rates are chosen

As was discussed above, in the classical banking theory framework banks do not choose the quantity of
loans they wish to make, but instead set the interest rate and the borrowing constraints and then allow
quantities to adjust given the prices that have been set. In an enforcement equilibrium, ∞, and as a
result there are no constraints on the quantity of loans that a bank can make.
Because banks choose price and not quantity, we analyze bank behavior using the framework of Bertrand
competition. That is, we assume that each bank sets its interest rate, taking what it expects the other banks
to do as given, and an equilibrium is found when each bank’s strategy is a best response to the other
banks’ strategies.
In each period a bank chooses the interest rate to maximize the expected value of the lending rate
multiplied by the loans that the bank expects to make, ℓ :
max ℓ
Because the banks under Bertrand competition simultaneously set the interest rate, i, that they will charge
non-bankers, non-bankers will bring all of their business to the bank that posts the lowest interest rate. We
assume that if more than one bank posts the lowest interest rate, then the market is split evenly between
the banks offering the low rate. As is well established, the best response of a bank is to set the rate
incrementally below the lowest rate set by the other banks if that rate is above cost and to set the rate at
cost if the lowest rate is at cost. For this reason, the only Nash equilibrium in Bertrand competition is for
banks to price their loans at cost. That is, the outcome of Bertrand competition is the competitive
outcome.
Given this structure the logic of Bertrand competition will mean that all banks set i = 0 since lending is a
costless activity and any bank that expects the other banks to set higher rates will try to capture the whole
market by setting a lower rate.
Observe that when banking is competitive, the right hand side of equation (9) is zero. In addition, as long
as the banks promise convertibility into the CM good, the left hand side of equation (9) is positive.
Therefore, when enforcement is exogenous and banking is competitive, carrying accepted bills from one
period to the next has no advantages. From this we can conclude that when banking is competitive
equation (9) is an inequality and the only enforcement equilibrium has d = 0. We state this formally as
follows:
Definition 1: A bank money equilibrium with enforcement is a set (i, p(A), d, q(A), x(A)) such that
equations (2), (5), (7), (8) and (9) are satisfied.
Proposition 1: When banking is competitive, i = 0, and the only monetary equilibrium with enforcement
has d = 0. In this equilibrium, production and consumption are first-best, q(A) = q**(A) and x(A) =
x**(A).

16 
 
Proof: Because β < 1 and ϕ = ϕ’ = 1, the Euler equations for cases 2 and 3 cannot be satisfied when
banking is competitive. Substituting i into (9), we find that the right hand side is zero, and thus that the
equation holds as an inequality. Then in any equilibrium d = 0. Substituting d = i = 0 into equations (5)
and (7), we find q(A) = q**(A) and x(A) = x**(A).■
When banking is competitive Proposition 1 tells us that Cases 2 and 3 are inconsistent with equilibrium:
because the only equilibria have d = 0, the cases where there is no borrowing given some realization of A
cannot take place in equilibrium.
Observe also that the monetary equilibrium with enforcement and competitive banking gives the first-best
outcome even though the Friedman Rule does not hold. In other words, when the monetary system is
based on the one that existed in the 19th century and was explained by classical banking theorists, the
first-best outcome is possible in the absence of deflationary monetary policy – if debt is enforceable.
Stationary equilibrium without enforcement
Now consider the case of an equilibrium without enforcement, where the repayment of debt must be
incentive compatible for the agents in our economy. The non-bankers will face the credit constraint, ℓ,
that ensures that they are never able to borrow so much that they would prefer to default rather than to pay
back the debt. Similarly the bankers will face the credit constraint, , which ensures that the value of
being a banker is greater than the value of taking advantage of the special economic function of a banker
in order to defraud the public and then suffer the consequences of bank failure.
In this section we focus on equilibria where accepted bills are not carried from one period to the next,
d = 0. (We will have more to say about equilibria with positive money balances in the next section.)
Before calculating and ℓ, we consider the problem faced by non-bankers. When d = 0 non-bankers
borrow in every state of the world, so in this case there are three types of equilibrium without
enforcement each of which is associated with a different value function. (The derivation of the value
functions is presented in Appendix 2.)

Case I: ℓ , late producers are never constrained by ℓ

Case II: ℓ , ℓ only binds when is realized

Case III: ℓ , late producers are always constrained by ℓ

Optimization in Case I, where the credit constraint is not in fact binding, was discussed (as Case 1) in the
previous subsection. In Case II ℓ only binds when is realized. The related value function is:

1 1 1
1 2 1

1 1 1 1 ℓ
1 ℓ
1 1 ℓ 1 0, 0 0
2

When VII(d) is lagged one period, simplified, and plugged into the CM optimization problem, we get:

17 
 
 1
1 1 1 ′ℓ 1 ′
1 2 1 2

1 0, 0 0

max

1
′ ′ 1 1 1 ′ 1 ′ ℓ ′
2

Before proceeding to solve the optimization problem, observe first that the maximization problem will be
the same for both late and early producers in the CM, and second that the second derivative in terms of d’
of the optimization problem is negative, so the solution to the problem is well defined. Take the FOC to
find the following Euler equation:
⁄ ′ 1 1
1 1 1 ′ (10)
2 2 ′ ℓ ′

A monetary equilibrium with no accepted bill holdings from one period to the next will exist only if the
marginal benefit of spending an accepted bill in the CM exceeds the marginal benefit of carrying it into
the next period. The latter marginal benefit is given by the right hand side of equation (10) and is
composed of the interest benefit earned by a late producer when productivity is low and the cost incurred
by a late producer when productivity is high and the bills are not carried into the next period together with
the incremental benefit due to a higher level of consumption when the liquidity constraint binds.
Equation (10) defines the maximum lending rate that is consistent with late producer optimization in a
Case II equilibrium. Our interest (for the present) is in equilibria where ϕ = ϕ’ = 1, and d = 0, so the
Euler equation gives us the following maximum value of i:
1 1 1 1
1 ≡ ̃
2 2 ℓ 1 1

Compare this to the constraint on i when the lending constraint never binds (from equation (9), the Euler
equation for Case 1):
1 1
1 ≡ ̂
1
and the Euler for Case III, where liquidity constraints always bind:
1 1 1 (11)
1 1 0
2 2 ℓ
In the latter case the marginal benefit of increasing d does not depend on i (or on the cost of interest
payments to be made in the CM), but instead on the increase in the FM consumption that d facilitates.

18 
 
The borrowing constraint for non-banks
The borrowing constraint for the non-banks ensures that the repayment of debt is always incentive
compatible. In the case of an equilibrium with d = 0 and no default for a non-banker, a late producer pays
back the loan with interest and gets the continuation value of the game, or:
ℓ, 0 1 ℓ 0
By contrast, the value to a late producer of entering the CM with loan, ℓ, and accepted bills, d, when the
late producer intends to default is represented by ℓ, . Default results in a loss of bank services and
without bank support no other member of the economy will accept the defaulter’s debt in payment, so the
continuation value of the game is autarky.13 Furthermore, a defaulter chooses not to produce at a loss so:
ℓ, 0
Then, the borrowing constraint for non-banks is:
ℓ, 0 ℓ, 0
When this equation holds with equality, it can be rewritten as a fixed point problem (taking into account
that our interest in this subsection is limited to equilibria where d = 0):
0; ℓ
ℓ (12)
1
Let ℓ∗ denote the solution to this problem.

Lemma 3: Given ℓ ℓ∗ , ℓ, 0 is decreasing in ℓ, and ℓ, 0 ℓ, for all ℓ ℓ.

Proof: ℓ, 0 1 ℓ 0; ℓ∗ and for all cases 0; ℓ∗ is independent of ℓ, the amount

of debt that the late producer carries into the CM in the current period. As ℓ, 0 is decreasing in ℓ
and is equal to zero at ℓ∗ , ℓ, 0 0 ℓ, for all ℓ ℓ∗ . ■

Banks: The problem of franchise value

Recall that banks have the technology to circulate their bills in the CM in order to purchase the CM good
even though this will leave them insolvent and that in both the CM and the FM they face the limit on their
liabilities, . At the end of a period in which a bank circulates such fraudulent bills the bank is bankrupt
and is forced into autarky. Here we discuss the banks’ incentive compatibility constraint first under
standard Bertrand competition and then under the assumption that the central bank sets a minimum
interest rate that acts as a floor when the banks engage in Bertrand competition.
First, consider the steady state value of being a banker at the start of a period, which we will represent by
Vb(i), where i is the steady state value of the interest rate. Then,

where Wb(L) is the value of being a banker at the start of the CM, given that loans L were made in the
FM. Vb(i) is the expected value of Wb(L) over both values of A. Furthermore

or the value of being a banker in the CM is the expected real interest paid to the bank plus the discounted
continuation value of being a banker in the future. And we can conclude that:
                                                            
13
This is similar to Gu, Mattesini, Monnet, & Wright (2013) where the penalty to being caught in default is autarky.
Note, however, that we do not adopt the whole of their framework. They assume that an agent is only caught
defaulting with a certain probability. This does not accord with the role of banks discussed in this paper, although as
a technical matter, such a probability can easily be added to the model.

19 
 
 1
where EL is the expected quantity of loans.

Let be the value of default to a banker who expects payment on loans outstanding, L, in the CM.
Then:

or is given by the funds paid to the bank in exchange for the loan plus the value to the bank of
issuing bills up to the bank’s constraint, as the continuation value of default in the next period is autarkic
and therefore zero. Recall that a bank must lend in the FM in order to be able to issue bills in the CM.
Banking is incentive compatible only if the bank will prefer not to default, when the bank’s loans – and
the interest to be paid on them – are at their lowest. For cases I and II incentive compatibility is given by:

1 1

For case III incentive compatibility is given by:

1 ℓ 1 ℓ

In order for a bank to have the borrowing capacity to compete for the whole of the market, as is presumed
by Bertrand competition, it must be the case that , the bank’s lending capacity is high enough to do so.

1 n min , ℓ (13)
is the mass of borrowers times the amount that they borrow, which is bounded above by ℓ. Here we
impose this borrowing capacity as a condition that must be met in order for the banking system to provide
the banking services depicted by classical banking theory. Thus, after simplifying the banks’ incentive
compatibility constraint, substituting in the FM value function, and imposing the condition that must be
high enough that the bank can afford to fund the maximum level of loans, we find for Case I:
(14a)

1 1
for Case II:

ℓ (14b)
1 1
and for Case III:

0 (14c)
1 1
Observe that in all cases as long as is greater than zero, then there exists some value of β such that
the incentive compatibility constraint will be met for all β greater than that value.
Under Bertrand competition, however, i = 0 and the incentive compatibility constraint for bankers is
always violated in the cases where ℓ may not bind. This fact provides us with valuable insights about the
nature of banking – which were understood by classical banking theorists – but are much less familiar to
modern theorists.
First, banking is an incentive compatible profession only if bankers earn some positive rate of interest on
their loans over and above the costs of making them. Thus, a competitive banking sector is not consistent
with the expansion of the money supply by banks on an unsecured basis, since it implies that the incentive

20 
 
compatibility constraint for bank provision of such monetary services will be violated. This is stated
formally in Lemma 4.
Lemma 4: Competitive banking, where the interest rate reflects only the zero costs of banking, is not
incentive compatible in environments where the liquidity constraint does not always bind on non-bankers.
Second, only when the banking sector is structured such that there is a franchise value to banking,
Vb(i) > 0, is bank provision of a reputation-based money supply incentive compatible. Thus, this
theoretical analysis indicates that the early 20th century monetary system described by classical banking
theory depended fundamentally on a banking sector that was not perfectly competitive, but instead that its
stability was founded on mechanisms that restrained competition, such as the “spirit of cooperation” that
characterized the banking system in Britain at this time.14
It is straightforward to show that the left hand side of equations (14a) and (14c) are increasing in i and
that the left hand side of equation (14b) is increasing in i for β > ½. This gives us Lemma 5, which is
proved in the appendix.
Lemma 5: Given d = 0:
for Case I there exists ̆ such that equation (14a) is true for ̆;
for Case III there exists ̆ such that equation (14c) is true for ̆ ; and
for Case II, when β > ½ and equations (12) and (14b) can be jointly solved to find ℓ∗ and ̆ , then
equation (14b) is true for ̆ .
Given that competitive banking is not incentive compatible, we now assume that banking is regulated and
that there is a central bank that limits competition by setting a minimum interest rate that banks can
charge at the level, ̌. Bertrand competition takes place subject to this minimum. As a result, the
regulatory authority is successful in setting the interest rate that banks charge at the level, ̌. This gives
banks the franchise value, ̌ , and it is the franchise value that makes banking incentive compatible.

Definition 2: A bank money equilibrium with unconstrained credit is a set (i, p(A), q(A), x(A), d, ℓ, )
such that equations (2), (5), (7), (8), (9), (12), and (13) are satisfied, (14a) holds as an equality, and
ℓ.
Lemma 6: If d = 0 and the non-bank borrowing constraint never binds, then when n + σ ≥ 1 there exists i
such that ̂ ̆ , and when n + σ < 1, there exists i such that ̂ ̆ , if
2
1
Proof: When d = 0 and the non-bank borrowing constraint never binds, Case I applies and

1 1 1
≡ ̂ ̆ ≡
1
1

                                                            
14
W.T.C. King describes the evolution of a banking sector from one in which competition tended to drive interest
rates down excessively to one in which the “the various elements in the [money] market … had become merged into
one organic whole around the nucleus of the Bank [of England].” King (1972) pp. 317, 321. Charles Goodhart
observes that this framework omits an alternative enforcement mechanism: early 20th century banking developed in
an environment where the assets of wealthy bankers were at risk, and there is indeed little doubt that the actual
enforcement mechanisms were more complicated than those in the model.

21 
 
which can be rewritten:

2 1

The two results follow.■

Proposition 2: Given n + σ ≥ 1 or n + σ < 1 and , there exists a critical value such

that a bank money equilibrium with unconstrained credit and d = 0 exists for all .
Proof: Assume that d = 0 and the non-bank borrowing constraint does not bind. By Lemma 6 there exists
i such that equation (14a) holds with equality and equation (9) is satisfied. As
1 1 , equation (14a) can be rewritten:

1

1
In a bank money equilibrium with unconstrained credit, equation (14a) holds as an equality or ̆ .
Observe that ̆ is strictly decreasing in β.
The value function that incorporates equations (2), (5), (7), (8), and d = 0 is:
1
0 1 1 1
1 1 ̆ 2 1 ̆

Plug this into equation (12) to get:

ℓ∗ 1 ̆ 1 1 1
1 2 1 ̆

Confirm that the assumption that the non-bank borrowing constraint does not bind is met or that
ℓ∗ ̆ . This inequality simplifies:

1 (15)
1
1 21 ̆
1
When this equation is satisfied, then there is a bank money equilibrium with unconstrained credit
composed of:
̆ , satisfying equation (14a) and by Lemma 6 equation (9)
p(A) given by equation (6b)
q(A) given by equation (5)
x(A) given by equation (7)
d=0
ℓ given by equation (12)
and given by equation (13)
Because the left hand side of equation (15) is strictly increasing in β and when β is at a minimum takes on
the value of 0 and when β is at a maximum takes on the value of ∞, there exists at which equation
(15) holds with equality. For , the left hand side of equation (15) increases and the equation holds

22 
 
as an inequality. By equation (14a) there exists ̆ ̆ which is a solution to (14a) for the new β,
and by Lemma 6, ̆ also satisfies equation (9). Therefore, there is a bank money equilibrium with
unconstrained credit for all . ■
Definition 3: A bank money equilibrium with partially constrained credit is a set (i, p(A), q(A), x(A),
d, ℓ, ) such that equations (2), (5), (7), (8), (10), (12), and (13) are satisfied, equation (14b) holds with
equality, and ℓ .

When evaluating bank money equilibria with partially constrained credit, our two incentive compatibility
constraints give us two fixed point problems, equations (12) and (14b), that must be jointly solved. We
give numeric examples of these equilibria.
Example 1: of bank money equilibrium with partially constrained credit
Assume , , , 1, 10, then we graph the following as a function of β.

ℓ 
̆  
̆
̂  
̆  

From the graph we can see that the conditions for a bank money equilibrium with partially constrained
credit are met when 0.47 < β < 0.67. That is, for these values of β borrowing is constrained only when
is realized, i.e. ̆ ℓ ̆ . Furthermore, we see that ̂ ̆ for all β.

23 
 
By adjusting parameter values it is possible to find partially constrained credit equilibria with higher
values of β.
Example 2: of bank money equilibrium with partially constrained credit.
, , , 1, 40,

ℓ 
̆  
̆
̂  
̆  

Now we find that the conditions for bank money equilibrium with partially constrained credit are met
when 0.59 < β < 0.92. For these values of β, ̆ ℓ ̆ and once again ̂ ̆ for
all β.

Definition 4: A bank money equilibrium with totally constrained credit is a set (i, p(A), q(A), x(A), d, ℓ, )
such that equations (2), (5), (7), (8), (11), (12), and (13) are satisfied, equation (14c) holds with equality,
and ℓ.

Once again, analytic solutions are not possible, and bank money equilibria with totally constrained credit
must be evaluated using numeric methods. Because the analysis of equilibria with partially constrained
credit make it clear that constrained credit equilibria can only be sustained when β is very low, bank
money equilibria with totally constrained credit are not of sufficient interest to analyze here.
Comments on bank money equilibria without enforcement:
The interest rate that must be charged on loans in order for banking to be incentive compatible acts as a
tax on consumption, which is less than it would be in the first-best.
The early producer who is willing to take the accepted bill as a means of payment will do so because she
knows that the banks’ incentives are aligned: the banks need to make only good loans in order to avoid
bankruptcy themselves, so the banks will manage the incentives of the late producers so that they are
aligned. Because incentives are aligned, the accepted bill will have value in the CM to late producers who
need to deposit accepted bills with the bank in order to make good on their loans. In other words,
accepted bills circulate as money, because they are backed by debt.

24 
 
The tension between competition and incentive compatibility in banking was recognized by classical
banking theorists. Indeed, this problem was viewed as the most important issue in the debate between
advocates of free banking and advocates of a central bank dominated banking system.15 This fundamental
tension continues to be recognized by modern banking scholars such as Charles Goodhart.16 And it is a
natural framework for explaining many aspects of the recent crisis: competition between banks promoted
the entry of banks that lowered origination standards for mortgages in order to gain market share, then the
established banks could only maintain market share by lowering their own standards, and the overall
effect on the market was to destabilize the banking system as the profits from banking were no longer
consistent with incentive compatibility and many loan originators, such as New Century, went bankrupt.
As the model indicates, this dynamic is as old as banking itself.
III. The role played by fiat money in an acceptance banking system

This section investigates the relationship between fiat money and classical banking theory. We show that
in an economy where credit constraints do not bind on non-banks, the welfare of non-banks can be
improved by the introduction of fiat money. The reason for this is simple: while credit is abundantly
available, it is also available only because interest rates are positive – and in the presence of positive
borrowing rates, fiat money improves the outcome for non-banks by reducing the sum that they need to
borrow and therefore the interest that they must pay. At the end of this section we discuss this result as a
counter-example to Gu, Mattesini and Wright (2014)’s claim that in environments where credit
constraints do not bind, money is useless and where money is essential, credit is irrelevant.
To understand the role played by fiat money, we amend the model presented in the previous section:
banks now have a policy that their liability on an accepted bill terminates at the end of the period in which
the bill was issued. For this reason, timely depositing of accepted bills by late producers (who receive the
bills in the CM) is essential. Into this environment we introduce fiat money.
To keep the notation parsimonious, let accepted bills now be denominated in the same units as money. As
a result the growth rate of the fiat money supply will determine the value of both accepted bills and
money over time.
The central bank controls the rate of money growth which is denoted by γ:

where the money stock at the current date is given by M, and the next period money stock by M’. Money
growth is implemented by lump-sum transfers, τ, to agents at the start of the CM, before the uncertainty is
realized, so aggregate transfers, 1 . Observe that whenever 1, the central bank must
have some enforcement technology that allows it to tax money holdings. In this paper, we assume that
such a technology exists.
Because we focus on symmetric stationary equilibria, at the end of each period the real value of money
balances is constant or
′ ′
and the focus in this paper (as in BCW) is on equilibria where the growth rate of money is constant so
that:

                                                            
15
Vera Smith, The Rationale of Central Banking 88, republication of 1936 edition (1990).
16
Charles Goodhart, The Evolution of Central Banks 48 (1988).

25 
 
Let m be the money holdings of a non-bank at the start of the current period. Then the initial analysis of
Section II can be duplicated, replacing d with m. The details are in the appendix.
An early producer who optimizes chooses q to satisfy equation (5) just as in the case without fiat money.
The intertemporal optimization condition for non-banks, equation (4), is the same except that m is
substituted for d: ′ ′ . Similarly, a late producer who optimizes chooses x to satisfy an equation
that is the same as equation (7), given the substitution of m for d.

if 0
(16)
. . if 0
, , ℓ,
if ℓ
1
ℓ
otherwise

Stationary equilibrium with fiat money and commercial bills

In this section we explore the existence of steady state equilibria in which m > 0. Because our goal is to
show how money and credit can circulate together and to provide a potential counterexample to GMW,
we limit our attention to the simplest case – the one in which the non-bank credit constraint, ℓ, never
binds, ℓ , and late producers always borrow, . This corresponds to
Case I of the model without fiat money. We show that there are equilibria with money in which
borrowing takes place in all states of the world, and that there are equilibria in which both accepted bills
and money circulate.
The intertemporal Euler equation for this economy (derived in the appendix) must hold with equality in
an equilibrium with positive money balances, and is given by:
1
1 (17)
1
As in the version of the model presented in section II, the non-bank incentive compatibility constraint
determines the real borrowing constraint ℓ. In order to solve for a steady state value function, rewrite
the FM value function so that the argument is real balances, . Then the steady state value of
is:
1
1 1 1 1
1 1 2 1

And the non-bank incentive compatibility constraint is:

(18)
ℓ
1

Similarly, the bank incentive compatibility constraint still determines the minimum level for the interest
rate in any equilibrium with credit. Banking is incentive compatible only if, when the bank’s loans are at
their lowest, the bank will prefer not to default or if:

26 
 
 1 1

We adjust the level of the real bank credit line, , that is necessary to support non-bank FM
consumption to take into account that the non-banks carry money into the FM:

1 (19)

and we find once again the same incentive compatibility constraint for banks, equation (14a):

1 1
The expected quantity of real loans in the environment with money must also be adjusted for the fact that
non-banks hold money:

1 1

Without loss of generality, rewrite ϕm as a fraction ∈ 0, of the loan a non-bank expects to take out if
the non-bank does not hold money:

1 (20)

where

≡
1
Observe that θ does not lie between 0 and 1, but between 0 and because our analysis is limited to
equilibria in which borrowing takes place for all realizations of A. is defined such that late producers
will borrow even when is realized. Then, the expected quantity of real loans is:

1 1 1

For expositional purposes define

≡
1
and observe that is greater than one. The incentive compatibility constraint for banks in the economy
with fiat money can now be rewritten:
1 (21)
̆ ≡
1
As was the case in the bank money equilibrium, a fiat money equilibrium with bank credit can only be
supported if the lending rate is maintained above the competitive level. Thus, we continue to assume that
the central bank sets the minimum lending rate at ̆ , and that Bertrand competition ensures that this
minimum coincides with the equilibrium lending rate.
Observe also that in the presence of such a lending rate the intertemporal Euler, equation (17), indicates
that any money growth rate that is consistent with equilibrium in this economy must be greater than β. In

27 
 
other words, when the Friedman Rule is followed, that is, when γ = β, the interest rate is too low to
support credit.17

Definition 5: A fiat money equilibrium with unconstrained credit is a set (i, γ, p(A), q(A), x(A), m, ℓ, )
such that equations (2), (5), (16), (17), (18), and (19) are satisfied, equation (21) holds with equality, and
ℓ .

Proposition 3: Given ∈ 0, , there exists such that a fiat money equilibrium with unconstrained
credit exists for all .
Proof: Assume that the non-bank borrowing constraint does not bind. Then, the value function that
incorporates equations (2), (5), and (16), , can be rewritten using equation (20) as a function of
, :
1
1 1 1 1
1 1 2 1

Plug this into equation (18) to get:

ℓ 1 1 1 1
1 1 1 2 1

Confirm that the assumption that the non-bank borrowing constraint does not bind is met or that ℓ
.

ℓ 1 1 1
1 1 1 2 1

Simplifying this inequality and substituting for i from equation (21) we find:
1 1
1 2 1 2 1 / 1 1

Since the right hand side is a constant and the left hand side varies in β from 0 to infinity, whenever the
right hand side is non-negative, there exists such that this holds with equality, and when the right hand
side is negative, 0. Clearly, this equation will hold as an inequality for all . In a fiat money
equilibrium both equations (17) and (21) must hold with equality, so the growth rate of the money supply
is determined by θ and β:
1
1
1

                                                            
17
Note that the breakdown of financial intermediation near the Friedman rule is a result that arises in many
environments. See, for example, BCW (2007) at 185.

28 
 
Thus, given ∈ 0, for all , there is a fiat money equilibrium with unconstrained credit
composed of:
̆
γ given by equation (17)
p(A) given by equation (6b)
q(A) given by equation (5)
x(A) given by equation (16)
m given by equation (20)
ℓ given by equation (18)
and given by equation (19) ■
Lemma 8: Given an interest rate, ̆ ; , the steady state welfare of non-bankers is maximized at
.

Proof: The steady state value to a non-banker of carrying money balances determined by θ into the FM is:

1
1 1
1 1 2 1 1

And 0, when the derivative of the expression inside the curly brackets is greater than zero or
when:
̆ 1 2 1
1 1 2 1
1 2 1
1 0
1 1 1 2 1
or when:
1
2

Conclusion: Vk(θ) is increasing in θ for and decreasing in θ for . Or in other words, Vk(θ) is
maximized at .■

The intuition behind Lemma 8 is that as θ increases, banks are now earning interest on a smaller quantity
of debt, and the minimum interest rate at which it is incentive compatible for banks to support the
accepted bill system is therefore increasing too. Thus, the minimum interest rate set by the central bank
must increase in order for an accepted bill equilibrium to exist. While θ < ½, the benefit of reduced
borrowing outweighs the interest rate effect on non-bank welfare, and the reverse is true when θ > ½.

To illustrate, consider an example where n = α = σ = ½, 1 and 10. When no money circulates

and θ = 0, equation (21) indicates that 0.73 and equation (17) indicates that 0.37. By

contrast, when θ = ½ and non-bank welfare is maximized, equation (21) indicates that 1.46 and

equation (17) indicates that 0.73. Observe that in both cases γ is significantly less than 1.

29 
 
We have found that in an economy where credit constraints do not bind on non-banks, the welfare of non-
banks can be improved by the introduction of fiat money. Is this result a counter-example to Gu,
Mattesini and Wright (2014)’s claim that in environments where credit constraints do not bind, money is
useless and where money is essential, credit is irrelevant? Yes and no.
Fiat money indisputably improves the allocation relative to credit in the model above. It is also true,
however, that if bills accepted by banks are redeemable in future periods, then credit instruments can
function as substitutes for fiat money.
Fiat money equilibria are, however, distinguished by the fact that the size of the money supply is a control
variable. By contrast, in the version of the bank model without fiat money we have assumed convertibility
of bank money into the CM good since there is no central authority or other obvious means of controlling
the aggregate money supply in the pure bank money environment.
Thus, when accepted bills are held over time in the pure bank money environment, the intertemporal
Euler equation allows for only one interest rate: ̂ . Contrast this with the case where bank
money is denominated in fiat money and the quantity of fiat money is a control variable, γ. The variability
of γ makes it possible to support an equilibrium with an interest rate below ̂, and doing so is welfare
improving. In short, even in the environment where credit constraints do not bind, fiat money can play an
essential role in improving the welfare of non-banks.
An even more important point, however, is that this model gives a new explanation for why a non-interest
bearing assets such as fiat money can circulate: the relevant rate of return on fiat money is not the zero
interest rate that it “pays,” but the interest that it enables borrowers to avoid paying. In short, in a world
where people face a positive probability that they will borrow in every period the effective rate of return
on a non-interest-bearing asset that is accepted in payment is the borrowing rate. In such an environment,
there is no mystery as to why the public is willing to hold fiat money.
IV. Deposits as an isomorphic transformation of acceptance banking

While the foundations of modern banking lie in acceptance banking, modern researchers typically think
of the “traditional” banking model as that of taking deposits and holding loans on the balance sheet. There
is in fact a close connection between acceptance banking and deposit-based banking. Indeed, the
development of the modern deposit-based banking system is an early example of innovation driven by
regulatory arbitrage as I explain in this section.
First observe the basic properties of the acceptance banking system modeled in section II above:
(i) Bank liabilities are not issued by banks. Instead, late producers issue liabilities that the banks
accept.
(ii) Accepted bills circulate.
(iii) Accepted bills circulate because they are backed by debt. Since late producers need accepted
bills to settle accounts, early producers are willing to hold accepted bills in the interim.

30 
 
 (iv) Money is debt. Negative balances are not just the norm, but integral to the means by which
money is issued. As we see in this model, no deposits are needed in order for an acceptance
banking system to operate. Instead, the money supply is directly backed by loans.18
In other words, at the end of the FM:
ℓ>0 (Debt: Late producers issue bills, draw on credit lines)
d>0 (Money: Early producers hold accepted bills)
d-ℓ =0 (Money is debt)
In the mid-19th century this system of issuing money was constrained by government regulation of the
issue of bank notes, which (going beyond the model) were paid out by banks when they discounted
acceptances that were not yet mature. Over the course of several decades an old form of bank liability that
had not in the past played a significant monetary role, grew dramatically in importance, the bank deposit.
A borrower instead of applying to the bank for a credit line would apply for an advance. When the
advance was granted, a loan was made and funded by crediting deposits in the borrower’s bank account.
In other words, the bank’s assets would increase by the amount of the loan and the bank’s liabilities
would increase by the deposit that funded the loan – so the loans stopped being simple guarantees of
borrower debt and were brought on balance sheet. Now in order to spend the proceeds, the entrepreneur
would write a check drawing down the funds in the deposit account. (The equivalence between these two
forms of lending is explained using T-accounts in Tables 1a and 1b.) In short, when moving from the
acceptance to the deposit system in the middle years of the 19th century the banks simply “wrote up”
deposits by converting what had been credit lines into deposits.
Thus, in response to government regulation, the monetary system morphed into a new form that took
advantage of less regulated bank activities. Unsurprisingly, checks and bills are facially almost identical
instruments. The only differences are that the bill is only payable by the bank after the bank accepts it and
that the bill states the date on which it is payable; whereas a check is only payable if the account on which
it is drawn has sufficient funds, and a check is immediately payable and bears only one date, the date on
which it is created.
Consider the elements of deposit-based banking:
(i) Bank liabilities are issued by banks in the form of deposits, and late producers then draw
them down by writing checks.
(ii) Checks make it possible for deposits to circulate.
(iii) Deposits circulate not because they are backed by debt, but because they are backed by
banks.
(iv) In comparison with acceptance banking, advances replace negative balances, and checks
replace accepted bills. (Indeed, Wicksell’s discussion of banking is based on a deposit variant
of acceptance banking. See page 139.)
Thus, the model in this paper can be reinterpreted as a model of deposit-based banking. At the start of
every FM banks grant loans (i.e. “advances”) to the late producers in the full amount of the credit line, ℓ.
In exchange for the loans, late producers are paid in deposit accounts that then hold the full amount of
their credit line.

                                                            
18
See Wicksell’s discussion of money in which balances are borrowed and then paid off. Interest and prices at 139
ff.

31 
 
Now ℓ > 0 represents the draw (executed by check instead of bill) on the deposit account by the late
producers. d > 0 represents the transfer of claims on deposit accounts to the early producers. And d - ℓ =
0, because the deposits are drawn from one account and transferred to the other.
This model illustrates the historical fact that the predecessor of modern banking is acceptance banking.
Thus, the often repeated story that banking as we know it developed from custodial institutions such as
goldsmiths is not only unsubstantiated, but also extremely misleading. The resources held by the modern
banking system in the form of deposits do not have their origins in clients who bring gold or other
valuables to a place of safe keeping. Deposits as we know them originated from the credit lines that were
an integral part of the acceptance banking system, and the deposit base was created by a banking system
that was innovating around the quantitative restrictions that had been placed on the issue of bank notes.
Just as in the reinterpretation of the acceptance banking model here, monetary economists alive at the turn
of the 20th century understood deposit banking through the framework of acceptance banking, treating the
quantity of deposits as determined by the demand of borrowers for loans, not by investors looking for a
mutual fund-like risk-sharing arrangement.19
V. Conclusion

This paper models the 19th century British banking system and draws connections between the need for a
money supply that fluctuates with productivity shocks, bank liabilities as the principal form of money,
and the role played by privately issued unsecured debt in backing the money supply. These are all
concepts that are fundamental to classical banking theory. The paper also demonstrates that, when
unsecured debt backs the money supply, competition will be destabilizing because it undermines the
franchise value that makes banking incentive compatible.
When the model is extended to incorporate fiat money we find a simple explanation for why the public
holds non-interest bearing assets: these assets can be used in payment and they reduce the amount that the
public will need to borrow. Thus the relevant interest rate is the cost of borrowing that has been avoided,
not the interest that the asset pays directly. We also find that in the fiat money environment the ability to
control the growth rate of the money supply is welfare improving relative to the bank money environment
where convertibility is used to control the growth of the money supply.
Whether or not there is a stationary equilibrium with fiat money only – where the Friedman Rule is
obtained – in this environment is a question left for future work. If such an equilibrium exists, it would
appear to dominate the credit equilibria in terms of welfare because the interest costs of debt would be
eliminated. We observe here, however, that the introduction of a measurable set of non-banks with no
endowment of money will have very different effects in a money only and a money with credit
equilibrium: the late producers in this impoverished set of agents can consume at date 0 in an equilibrium
with credit, but go hungry in an equilibrium with money only. The equalizing effects of general access to
credit is another of the benefits of bank money equilibria that merits further exploration.

                                                            
19
See, e.g., Knut Wicksell, Interest and Prices 110 (R.F. Kahn transl., 1898) (“We have seen that in our ideal state
every payment, and consequently every loan, is accomplished by means of cheques or giro facilities. It is then no
longer possible to refer to the supply of money as an independent magnitude, differing from the demand for money.
No matter what amount of money may be demanded from the banks, that is the amount which they are in a position
to lend (so long as the security of the borrower is adequate). The banks have merely to enter a figure in the
borrower's account to represent a credit granted or a deposit created. When a cheque is then drawn and subsequently
presented to the banks, they credit the account of the owner of the cheque with a deposit of the appropriate amount
(or reduce his debit by that amount). The "supply of money" is thus furnished by the demand itself.”)

32 
 
Another area that is left for future work is the study of other roles played by fiat money. In particular,
there is an important gap in our bank money model: off the equilibrium path of play our banks have no
means of honoring their promise to convert accepted bills into the CM good. If the central bank has a
repository of the CM good, then central bank notes can be used as reserves for our banking system, and
by holding such notes our banks can ensure that they have the capacity to honor their promises.
More generally, in classical banking theory both the central bank, and more importantly the central bank
note – or fiat money – play an important role in stabilizing the banking system and averting a transition to
an autarkic no credit equilibrium. The central bank note is both the means of settlement for the banking
system, and, because the quantity of central bank notes outstanding is under complete control of the
central bank, it is also an extremely quick tool for expanding the supply of such central bank liabilities
(that is, M0) whenever “panic” sets in or the public’s willingness to hold bank liabilities (that is, M1 or
M2) declines suddenly.
Thus, future work will study the case where banks hold non-interest-bearing central bank liabilities as
reserves, and where the costs of holding such assets are borne directly by the banking system and only
indirectly by the public.20 A model of endogenous default will also illustrate the stabilizing role of central
bank notes.

                                                            
20
 Wicksell 139-40.

33 
 
References

Aleksander Berentsen, Gabriele Camera, & Chris Waller, Money, Credit, and Banking, 135 J Econ.
Theory 171 (2007).
Ricardo Cavalcanti and Neil Wallace, A Model of Private Banknote Issue, 2 Rev. Econ. Dynamics 104
(1999a).
Ricardo Cavalcanti and Neil Wallace, Inside and Outside Money as Alternative Media of Exchange, 31 J.
Money, Credit, & Banking 443 (1999b).
Rebecca S. Demsetz, Marc R. Saidenberg, and Philip E. Strahan, Banks with Something to Lose: The
Disciplinary Role of Franchise Value, FRBNY Econ. Pol. Rev. 1 (Oct. 1996).
Charles Dunbar, Chapters on Banking (1909).
Charles Goodhart, The Evolution of Central Banks (1988).
Antoine Martin and Stacey Shreft (2005). Currency Competition: A Partial Vindication of Hayek. Federal
Reserve Bank of Kansas City Research Working Paper No. RWP 03-04.
Gu, Mattesini, Monnet, and Wright, Banking a New Monetarist Approach, 80 Rev. Econ. Stud. 636
(2013).
Gu, Mattesini, and Wright, Money and Credit Redux (2014).
Ralph Hawtrey, Currency and Credit (1919).
Timothy Kehoe & David Levine, Debt-Constrained Asset Markets, 60 Rev. Econ. Stud. 865 (1993).
W.T.C. King, History of the London Discount Market (1972).
Narayana Kocherlakota, Money is Memory (1998).
Ricardo Lagos & Randall Wright, A Unified Framework for Monetary Theory and Policy Analysis, 113
J. Pol. Econ. 463 (2005).
Perry Mehrling (2012). Three principles for market based credit regulation, AER 102(3), pp. 107-112.
Cyril Monnet and Daniel Sanches, Private Money and Banking Regulation, FRB Philadelphia Working
Paper 15-19 (2015).
Ed Nosal and Guillaume Rocheteau, Money, Payments, and Liquidity (2011).
Daniel Sanches, On the Inherent Instability of Private Money, FRB Philadelphia Working Paper 15-18
(2015).
Thomas Sargent & Neil Wallace, The Real Bills Doctrine vs. the Quantity Theory: A Reconsideration, 90
J. Pol. Econ. 1212, 1213 (1982).
R.S. Sayers, Central Banking after Bagehot (1957).
David Sheppard, The Growth and Role of U.K. Financial Institutions 1880 – 1962 (1971).
Adam Smith, Wealth of Nations (1776).

34 
 
Vera Smith, The Rationale of Central Banking, republication of 1936 edition (1990).
Knut Wicksell, Interest and Prices (R.F. Kahn transl., 1898).
H. Parker Willis, American Banking (1916).

35 
 
Appendices

Appendix 1: Derivation of Value Functions Under Enforcement

It is convenient for purposes of exposition to substitute out the equilibrium price level when defining
expressions for the optimal consumption of good x, ∗ , ℓ, , the optimal supply of good x, ∗ , ℓ, ,
and the resulting income received from the sale of good x, ∗ , ℓ, .

For optimal consumption, we find:

0 if 0
. . if 0
∗
, ℓ, if ℓ

ℓ
otherwise
1
where

≡
1 1
The optimal supply of the FM good is given by:

0 if 0
. . if 0
∗
, ,ℓ if ℓ

1 ℓ
otherwise

where
1
≡
1
And the resulting income received from the sale of the FM good is:
1
0 if 0

. . if 0
∗
, ,ℓ 1
if ℓ

1 ℓ
otherwise

where

36 
 
 1
≡
1

Then the value function for Case 1: Always borrow, ϕd ≤ , is:

1
1 1 ,0

1

2
1
1 ,0

1

2

And we can rewrite 1 ,0

1 1
1 1 0,0
1 1 1

1 1 1

1 2 1

1 1
1 1
1 2 1
1 1 0 1 0,0

1
1 1
1 2 1
1 1 0 1 0,0

1 1 1 1 0 1
1 2 1
0,0
Thus we can conclude that Case 1 gives us the following value function:

37 
 
 1 1 1
1 2 1
1 1 0 1 0,0

Case 2: Never borrow, ϕd ≥ 0

1
1 1 0 0, 0

0 1
0
2
1
1 0 0, 0

0 1
0
2

Following the same method as for Case 1, we find:

1 1 1 0 1 0,0
2

Case 3: Splitting, ∈ 0 ,

1
1 1 0 0, 0

0 1
0
2
1
1 ,0

1

2

Following the same method as for Case 1, we find:

1 1 1 1
2 2 1 1
1 1 1 1 0 1 0,0

Appendix 2: Derivation of Value Functions without Enforcement

Equilibria when d = 0 and ℓ sometimes binds

38 
 
Case I, in which the borrowing constraint never binds, is identical to Case 1, which was derived above.

Case II: Always borrow and ℓ only binds for , ℓ

1
1 1 ,0

1

2

ℓ
1 ℓ, 0
1

1 ℓ 1 ℓ

2

After some algebra we get:

1 1 1
1 2 1

1 1 1 1 ℓ
1 ℓ
1 1 ℓ 0 1 0,0
2

Case III: Always borrow and ℓ always binds, ℓ

ℓ
1 1 ℓ, 0
1

1 ℓ 1 ℓ

2

ℓ
1 ℓ, 0
1

1 ℓ 1 ℓ

2

After some algebra we get:

39 
 
 1 ℓ 1

1 ℓ
1 1 ℓ 0 1 0,0
2

Appendix 3: Proof of Lemma 5

Lemma 5: Given an equilibrium with d = 0
for Case I there exists ̆ such that equation (14a) is true for ̆;
for Case III there exists ̆ such that equation (14c) is true for ̆ ; and
for Case II, when β > ½ and equations (12) and (14b) can be jointly solved to find ℓ∗ and ̆ , then
equation (14b) is true for ̆ .
Proof: Case 1: The EL in this case is:

1 1

Then, equation (14a) can be rewritten:

1
0
1
where implies the final inequality. Therefore, in this case the i that solves equation (14a) is ̆ 0.

Since the left hand side of equation (14a) is increasing in i, we can conclude that equation (14a) is true for
̆.

Case III: Equation (14c) holds with equality at ̆ 0. Furthermore,

1 ℓ
so the left hand side of equation (14c) can be rewritten:

ℓ
1 1 1
which is increasing in i for all values of i, and we can conclude that equation (14c) is true for ̆ .
Case II: The EL in this case is:
1
1 ℓ

Then, equation (14b) holds with equality when:

ℓ 1 1 ℓ 1
1 1 1

where ≡ . A Case II equilibrium exists when this equation can be jointly solved with
∗
equation (12) to find ℓ and ̆ . We show numerically in the text that such a solution often exists.
The derivative of the right hand side of the latter expression in terms of i is:

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 ℓ 1 2 2
1 1 1
1 1 2 2
ℓ 1 2 1 2
1
1 1 2 1 2 1

and after some algebra we find that the expression inside the curly brackets is greater than zero when
2 1
4 2 1 1 2
Therefore, when β ≥ ½ and we can solve numerically for ̆ , equation (14b) is true for ̆ .■

Appendix 4: Introduction of money

A. The Early producer’s Problem: In the CM the early producer maximizes
, max ,
subject to

where d represents the accepted bills received by the early producer in the CM. Substituting out for X, we
find:
, max
0,0

Once again we find that the first order condition for the choice of m’ is independent of m and is given by:
′
The envelop conditions are:

After the realization of uncertainty at the start of the FM the early producer’s problem is:
1
max ,
2
where w is any cash payment received in exchange for the goods. The first order condition for this
problem is equation (5):
∗ (5)
,
B. The Late producer’s Problem: In the CM the early producer maximizes
,ℓ max ,
subject to
1 ℓ
which can be rewritten:
,ℓ 1 ℓ max
1 ℓ 0,0
The envelop conditions for the late producer are:
ℓ 1

When a late producer brings money into the FM, the fact that i ≥ 0 ensures that the late producer will

41 
 
prefer to spend money that was brought into the FM rather than holding it and taking out a loan to make
up the difference. This gives two cases:
Case 1: m– px ≥ 0
The late producer’s problem is:
max ,0
The first order condition for this problem gives:

Case 2: m – px < 0
The late producer’s problem is:
max 0,
subject to
ℓ
The first order conditions for these two problems, the equilibrium prices and the late producer’s FM
expenditure are identical to the case without money, substituting m for d whenever the borrowing
constraint binds. Similarly, Lemma 1 and Lemma 2 apply to steady state levels of m just as they did to
steady state levels of d.
Then the late producer’s demand function is given by:

if 0

. . if 0
, , ℓ, (16)
if ℓ
1
ℓ
otherwise

C. Derivation of the Euler equation in the case where (i) m is never sufficient for late producers’
purchases in the FM and (ii) the borrowing constraint never binds.
The value of bringing fiat money holdings, m, into the FM is given by:

1 1 1 1 1
1 2 1
0,0 1 0, 0
(Note that receipt by an early producer of cash instead of acceptances has no effect on the early
producer’s welfare.)
The first order condition for this is:
1
And intertemporal optimization requires:
′ ′ ′ ′ 1 ′
or

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 ⁄ ′
1 1 ′
Substituting for the growth rate of money we find the Euler equation:
1 1 ′

D. Steady state value of bringing ϕm into the FM. Observe that in equilibrium, it must be the case that the
money holdings carried into the next period, m’, equal the money supply at the end of the last period, M,
which in turn is equal to (1 + τ)M-1. Thus, the steady state value of carrying real money balances, ϕm, into
each period is given by:
1
1 1 1 1
1 1 2 1

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