A model is produced in which labor contracts that prespecify (unindexed) nominal wage payments arise endogenously. These contracts function as a self-selection mechanism. Under appropriately different attitudes toward price-level risk (which can either arise directly from preferences or be induced by different patterns of asset holdings), nominal contracts allow high-productivity workers to signal their type by their willingness to accept unindexed contracts. This explanation of nominal contracts does not require that money be used in any particular set of transactions, and nominal contracts enhance the risk faced by all parties accepting them.

A real business cycle model is constructed in which workers are heterogeneous and privately informed about their own productive abilities. The model is structured so that interesting cycles cannot arise in the absence of the informational asymmetry. In the presence of this asymmetry, the model produces cyclical fluctuations that are consistent with features of observed business cycles. Hours behavior of individuals is also consistent with micro evidence. In addition, the model gives rise to equilibrium unemployment of labor. The determination of equilibrium unemployment rates, hours levels, and output are integrally related in the analysis.

Friedman's (1960) proposal to pay interest on (required) reserves is considered in a setting that eliminates the indeterminacy of steady-state equilibrium discussed by Sargent and Wallace (1985). In an overlapping-generations model where the real rate of interest is technologically determined, the payment of interest on reserves results in a determinate, Pareto optimal steady-state equilibrium. However, interest payments on reserves reduce the steady-state welfare of all young agents and, for many economies, result in the existence of stationary sunspot equilibria. This is the case even if such equilibria cannot exist when reserves do not earn interest.

We consider risk-neutral firms that must obtain external finance. They have access to two kinds of stochastic investment opportunities. For one, return realizations are costlessly observed by all agents. For the other, return realizations are costlessly observed only by the investing firm. We examine the optimal allocation of investment between the two projects and the optimal contract used to finance it. The optimal contractual outcome can be supported by appropriate (and determinate) quantities of debt and equity issues. Investments in projects with CSV problems are associated loosely with debt. Investments in projects with observable returns are associated with equity. Journal of Economic Literature Classification Numbers: G21, E51.

A model is presented in which governments can select real expenditure levels that are feasible, but are sufficiently high that a balanced budget is impossible. Thus, governments with large expenditures are committed to inflationary finance schemes. This is the case, even though the governments in question have access to lump-sum taxes. In addition, the model can explain why poorer countries tend to make heavier use of the inflation tax than do wealthier countries, and can account for the existence of country-specific fiat monies. The government that does not have access to the printing press can, nonetheless, use emergency taxes or compulsory loans for emergency financing. S.Fischer [1982, p. 297]

Banking crises are frequent events. Gerard Caprio and Daniela Klingebiel (1997) catalog over 80 banking crises during the last 25 years. Interestingly, some banking crises are associated with no output losses whatsoever, while others involve massive recessions. Finally, it is known that the probability of a banking crisis rises as the rate of inflation rises (see Asli Demirguc-Kunt and Enrica Detragiache, 1997; John Boyd et al., 2001a, b). While received wisdom exists about the conduct of monetary policy while a crisis is underway, there is no formal treatment of how the conduct of monetary policy during “normal times” affects the potential for banking crises to occur. To fill that gap, I consider economies where spatial separation and limited communication create a transactions role for money, and random shocks to agents’ liquidity preferences create a role for banks. In addition, banks confront randomness in withdrawal demand. When withdrawal demand is sufficiently high, banks exhaust their cash reserves. There are good reasons to associate this with a banking panic. The output lost during a banking panic depends on how great withdrawal demand is. Some banking crises generate no output losses, while others generate large reductions in resource availability. In addition, the conduct of monetary policy during “normal times” affects the probability of a banking crisis. The higher the nominal interest rate (the inflation rate), the higher is the probability of a panic. Driving the nominal interest rate to zero (following the Friedman rule) eliminates bank panics. This constitutes a new rationale for the Friedman rule. Nonetheless, conventional methods of implementing the Friedman rule never produce an optimal resource allocation. In particular, low nominal interest rates induce banks to hold large cash reserves, thereby forgoing socially more productive investments. In effect, the Friedman rule induces banks to become narrow banks voluntarily. The banking system is very safe, but it undertakes a suboptimal level of investment. Less conventional methods for implementing the Friedman rule, such as allowing unrestricted access to the discount window at a zero nominal interest rate, lead either to the nonexistence of equilibrium, or to massive indeterminacies. None of the equilibria will be consistent with full optimality.

This paper considers two questions: (i) what is the purpose of legal restrictions intended to separate "money" from "credit markets," and (ii) is such a separation desirable? It is argued that historical legal restrictions meant to achieve such a separation were designed to preclude the occurrence of sunspot equilibria. It is also shown that a coherent model can be constructed in which sunspot equilibria exist in the absence of legal restrictions, but not if money and credit markets are separated. Nevertheless, there is no obvious welfare justification for such a separation.

Recent developments in monetary economics stress the nature of monetary injections, emphasizing that they have implications for the relationship between money and prices. In contrast, traditional approaches posit stable money demand functions that are independent of how money is injected. The former approach implies that certain proportionality relations between money and prices need not obtain. This permits the two approaches to be empirically distinguished, but only if an appropriate "experiment" is conducted. The colonial period is one such experiment. Colonial evidence suggests that the nature of injections is crucial to the effect on prices of changes in the money supply.

This article presents a monetary growth model where spatial separation and limited communication create a role for banks. Monetary policy interacts with the financial system's liquidity provision to affect the existence, multiplicity, and dynamical properties of equilibria. Moderate levels of risk aversion and tight monetary policy can lead to multiple steady states. Dynamical equilibria can be indeterminate, with oscillatory paths. Thus financial market frictions are a source of indeterminacies and endogenous volatility. Under plausible conditions, tight monetary policy raises the nominal interest rate and inflation rate and reduces long run output. Thus, a central bank's liquidity provision can promote growth.