A Simple Model of Money and Banking

This article presents a simple environment giving rise to banks that create and lend out money. We define money to be any object that circulates widely as a means of payment. In our model, this object takes the form of a fully secured and redeemable bearer bond. This monetary instrument is issued by an agent that can credibly commit to monitoring a pool of real investments; that is, this capital forms the requisite backing for a circulating private debt instrument. While direct trade in securities is feasible without money, we find that money can economize on monitoring costs, which enhances the efficiency of the exchange process. We define a bank as an agency that simultaneously issues money and monitors investments. In reality, banks also accept deposits of money, which are then redirected to borrowers. In our model, banks do not accept deposits; we do not view this function as a defining characteristic of a bank.1 In particular, financial markets also accept deposits of money in exchange for marketable liabilities (equity and debt instruments). We think that banks differ from financial markets in two ways. First, bank liabilities are designed to be high-velocity payment instruments (money). Second, banks specialize in screening and monitoring their investments. Banks in our model perform both of these functions. While our framework allows private non-bank liabilities to serve as the economy’s medium of exchange (as mentioned earlier, exchange is even possible without any money at all), we demonstrate that the cost-minimizing structure has a bank creating liquid funds, which are then lent to borrowers (for example, entrepreneurs) with suitable collateral (contingent claims against future output). These liquid funds constitute real bills of exchange; that is, they are backed by the issuing bank with enforceable claims against real assets (the collateral supplied by borrowers).