Imperfect Monitoring and the Discounting of Inside Money

One of the fundamental questions concerning inside money is whether its issuers should be regulated and how. This paper evaluates the e¢ ciency of one prevalent regulatory recommendation –a requirement that private issuers redeem inside money on demand at par – in a random-matching model of money where the issuers of inside money are only imperfectly monitored. I …nd that for su¢ ciently imperfect monitoring, a par redemption requirement leads to lower social welfare than if private money were redeemed at a discount. A central message of the paper is that if inside money and outside money are not perfect substitutes for one another, as is the case if there is su¢ ciently imperfect monitoring, a par redemption requirement may not be socially optimal because such a requirement e¤ectively binds them to circulate as if they are. Such an outcome is a version of Gresham’s law that bad money drives out good money.