Risk, Inside Money, and the Real Economy

Hugo van Buggenum

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Abstract

In modern economies, most money takes the form of inside money; deposits created by commercial banks to fund credit extension. Because inside money is used as a payment instrument, doubts about the risks associated with credit extension can affect aggregate outcomes. This paper constructs and analyzes a model of risky credit extension, inside money creation, and monetary exchange. When credit extension is sufficiently risky, a positive probability of bank default arises and this affects the return characteristics of inside money. Depositors then demand a risk premium for holding inside money, which drives a wedge between bankers' funding costs and the social benefits of money creation. This wedge negatively affects credit extension, output, and welfare. A government can restore efficiency by swapping risky inside money for risk-free forms of government debt.
Original languageEnglish
Place of PublicationTilburg
PublisherCentER, Center for Economic Research
Number of pages65
Volume2021-020
Publication statusPublished - 20 Jul 2021

Publication series

NameCentER Discussion Paper
Volume2021-020

Keywords

  • inside and outside money
  • Risk
  • policy
  • Investment
  • new monetarism

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