From Chapter 8, we have explained how banks can improve welfare by transforming illiquid capital into liquid deposits. An important by-product of this explanation is that there are two types of money: fiat money and deposits. One distinctive characteristic is that fiat, or outside, money is a liability of the monetary authority and a bank deposit, or inside money, is a liability of a commercial bank.
In this chapter, we want to extend the basic illiquid capital version of the model economy in which a bank offers liquid deposits. In order to have both inside and outside money valued in equilibrium, we introduce a legal restriction that forces fiat money to be valued; that is the reserve requirement. Here, the monetary authority may wish to regulate institutions creating inside money in order to control the total stock of money or to enhance revenue from seigniorage. To meet these ends, the monetary authority, which now may also be called a central bank, generally has two tools at its disposal – reserve requirements and loans to banks – in addition to its ability to print fiat money. At the end of this chapter, we show that loans to commercial banks, also known as discount window loans, are really just temporary ways to reduce reserve requirements.
We begin by offering a complete set of analyses studying the effects that changes in reserve requirements have on key economic outcomes. Note that people do not hold currency in this model economy. Instead, banks hold fiat money in the form of reserves. The most important takeaway is that we develop an approach in this chapter that serves as the first step toward a model that can account for why both fiat money and deposits coexist.
Legal Restrictions on Financial Intermediation
Financial intermediation allows privately created assets to serve as money. One consequence of permitting unfettered intermediation is that, if intermediation is not too costly to use and operate, people may choose to use inside money instead of fiat money. This will occur if the rate of return of inside money, net of transaction costs, exceeds that of government-created fiat money.
If people prefer inside money to fiat money for every use of money, fiat money will lose its value.