Mechanism Design and Payments∗

We introduce a model in which agents face random and unobservable needs to transact over time. We characterize the optimal setup for incentive compatible transactions, the optimal payment system. The existence of an equilibrium in which agents transact through a payment system might require certain caps on short-term borrowing. Networks that have knowledge of agents’ histories support efficient transactions among their members. If agents transact frequently outside their network, however, incentive constraints imply that internetwork transactions can take place only at the cost of fewer intranetwork transactions. Periodic settlement rounds are shown to be beneficial. Finally, the optimal payment system gives rise to a Friedman rule. ∗We thank audiences at the Bank of Portugal, CEMFI, the Cleveland Fed and the European Central Bank. We especially thank Ed Green, Benjamin Lester, and Neil Wallace for several comments and suggestions. The views expressed in the paper are not necessarily those of the ECB.