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]

[This paper describes an environment in which government-issued currency is dominated in rate of return and in which there obtains a Modigliani-Miller theorem for government open market operations. Earlier Modigliani-Miller theorems for government finance have been stated for environments in which government-issued currency is not dominated in rate of return in equilibrium. Since government-issued currency is widely observed to be dominated in return, it is useful to study how Modigliani-Miller theorems hinge on absence of rate of return dominance.]

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.

An endogenous growth model with multiple assets is developed. Agents who face random future liquidity needs accumulate capital and a liquid, but unproductive asset. The effects of introducing financial intermediation into this environment are considered. Conditions are provided under which the introduction of intermediaries shifts the composition of savings toward capital, causing intermediation to be growth promoting. In addition, intermediaries generally reduce socially unnecessary capital liquidation, again tending to promote growth.

Recent theories of corporate organization hold that mutually owned firms arise to remedy agency problems associated with ownership by a separate class of stockholders. We propose an alternative theory of mutuality, in which mutuals arise endogenously as a self-selection mechanism to cope with adverse selection and systematic risk. This theory makes predictions about the nature of customer contracts and the pattern of dividend payments adopted by mutuals. We do not systematically test this theory against others. But the behavior of the Farm Credit System, a large financial mutual, is shown to be more in accord with our theory.

Credit rationing is a common feature of most developing economies. In response to it, the governments of these countries often operate a number of programs intended to expand the supply of credit to the private sector. Expansionary monetary policy is often seen as a way of reducing the extent of credit rationing. We examine the consequences of a common policy tool in these economies: the use of expansionary monetary policy combined with direct central bank lending to inject credit. In the context of a small open economy we show that such a policy increases long-run production if and only if the economy is in a development trap. Moreover government credit programs often lead to endogenously arising aggregate volatility. Thus the case for government intervention in credit markets relies largely on the notion that output is artificially low because the economy is in a development trap. However, it is the case that the kind of policy we consider can be used to eliminate certain indeterminacies of equilibrium created by endogenous credit market frictions. Journal of Economic Literature Classification Numbers: E44, O16, O42.