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Money andBanking in SearchEquilibrium ¤

Ping He University of Pennsylvania

Lixin Huang City University of Hong Kong

RandallWright University of Pennsylvania

August 11, 2003


This paper develops a new theory of money and banking based on an old storyabout moneyand banking. Thestoryis that bankers originally accepted deposits forsafe keeping;then theirliabilities beganto circulate as means of payment (bank notes or checks). We develop models where moneyisa medium of exchange,butsubject to theft,wheretheft maybe exogenous or endogenous. We analyze how the equilibrium circulation of cashand demand deposits varies withthecost ofbanking and theoutside money supply. We study cases with 100% reserves and with fractional reserves.

¤ We thankKen Burdett,Ed Nosal, PeterRupert, Joseph Haubrich, Warren Weber, Fran- coisVelde, SteveQuinn andLarryNeal forsuggestionsorcomments. We thank the NSFand the FederalReserve Bank of Cleveland for¯nancial support. Theusual disclaimerapplies.


The theory of banking relates primarily to the operation of commer- cial banking. More especially it is chie°y concerned with the activ- ities of banks as holders of deposit accounts against which cheques are drawn for the payment of goods and services. In Anglo-Saxon countries, and in other countries where economic life is highly devel- oped, these cheques constitute the major part of circulating medium. EB (1954, vol.3, p.49).

1 Introduction

This paper develops a new theory of money and banking based on an old story

about money and banking. This story is so well known that it is described nicely

in standard reference books like the Encyclopedia Britannica: \the direct ances-

tors of moderns banks were, however, neither the merchants nor the scrivenors

but the goldsmiths. At ¯rst the goldsmiths accepted deposits merely for safe

keeping; but early in the 17th century their deposit receipts were circulating in

place of money and so became the ¯rst English bank notes." (EB 1954, vol.3,

p.41). \The cheque came in at an early date, the ¯rst known to the Institute of

Bankers being drawn in 1670, or so." (EB 1941, vol.3, p.68). 1

More specialized sources echo this view. As Quinn (1997, p.411-12) puts it,

\By the restoration of Charles II in 1660, London's goldsmiths had emerged as

a network of

Some were little more than pawn-brokers while others

1 To go into more detail: \To secure safety, owners of money began to deposit itwith the London goldsmiths. Againstthese sums the depositor would receive a note, which originally wasnothing more than areceipt, and entitled the depositor to withdraw hiscash on presen- tation. Twodevelopmentsquicklyfollowed,which were the foundation of`issue'and `deposit' banking,respectively. Firstly,thesenotesbecamepayable tobearer, andsoweretransformed froma receiptto a bank-note. Secondly, inasmuch asthe cash in question wasdeposited for

a ¯xed period, the goldsmith rapidly found that it was safe to make loans out of his cash resources, provided such loanswere repaid within the ¯xed period.

\The ¯rst result was that in place of charging a fee for their services in guarding their client's gold, they were able to allow him interest. Secondly, business grew to such a pitch thatitsoonbecame clearthata goldsmithcouldalwayshave acertainproportionofhiscash out on loan, regardless of the dates at which his notes fell due. It equally became safe for himto make hisnotespayableatany time,forso longashis credit remained good, hecould calculate on the law of averages the exact amountof gold he needed to retain to meet the dailyclaimsofhisnote-holdersand depositors." (EB 1941, vol.3, p.68). See Neal (1994)for

a discussion ofvarious other ¯nancial institutions and intermediaries at the time, including scrivenors, merchantbanks, country banks, etc.


were full service bankers. The story of their system, however, builds on the ¯-

nancial services goldsmiths o®ered as fractional reserve, note-issuing bankers. In

the 17th century, notes, orders, and bills (collectively called demandable debt)

acted as media of exchange that spared the costs of moving, protecting and

assaying specie." Similarly, Joslin (1954, p.168) writes \the crucial innovations

in English banking history seem to have been mainly the work of the goldsmith

bankers in the middle decades of the seventeenth century. They accepted de-

posits both on current and time accounts from merchants and landowners; they

made loans and discounted bills; above all they learnt to issue promissory notes

and made their deposits transferrable by `drawn note' or cheque; so credit might

be created either by note issue or by the creation of deposits, against which only

a proportionate cash reserve was held." 2

A story, even a very good story, is not a theory. What kind of a model could

we use to study banks as institutions whose liabilities may substitute for money

as a means of payment? Clearly we need a model where there is a serious role

for a medium of exchange in the ¯rst place. One such framework is provided

by recent work in monetary economics based on search theory. Of course, we

would need to relax the severe assumptions made in most of these models,

such as having all interaction take place in an anonymous bilateral matching

process, to even contemplate somethinglike a bank. Tothis end we adopt certain

aspects of the framework in Lagos and Wright (2002), where agents interact in

decentralized markets at some points in time and in centralized markets at other

points in time. At the same time, there would have to be some friction over and

above those in the typical search-based model to generate a role for a second

2 According to Quinn (2002), e.g., \To avoid coin for local payments, Renaissance mon- eychangers had earlier developed deposit banking in Italy, so two merchants could go to a bankerand transferfundsfrom one accountto another." Itseemshoweverthatthese earlier depositbanksdid notreallyprovidecheckingservices: transferringfundsfromoneaccountto another\generallyrequiredthepresenceatthe bankofboth payerand payee."(Kohn1999b).


means of payment, in addition to cash.

The historical literature gives us guidance here by telling us that money was

actually less than the ideal means of payment. Among other things, coins were

in short supply, were hard to transport, got clipped or worn, and could be lost or

stolen. With the expansion of commerce the need for a better means of payment

led to ¯nancial innovation, and in particular, the emergence of deposit banks

and bills of exchanges that reduced the need for actual cash (Kohn 1999a,b,c).

The idea presented here is exactly this: cash (outside money) is imperfect and

hence there arises a role for an alternative means of payment, which will be

¯lled by the demandable debt of banks (inside money). The sense in which

cash is imperfect in our model is that it is subject to theft while bank deposits

are relatively safe. More generally our focus is on banks' provision of payment

services, which today is important as ever, given recent moves towards hopefully

safer or more convenient services, including debit cards, electronic money, etc.

We hope this will provide not only a fresh perspective on banking, but will

also help to extend the search models to include some interesting institutions

other than simply money. 3

We like to think of this alternative institution {

these deposits in ¯nalcial intermediaries { as representing in a stylized but rea-

sonable way modern checking accounts, or perhaps traveler's checks, because

in addition to their relatively high degree of acceptability a key feature is their

safety. This seems consistent with the historical view of the services provided

by banks or more generally by bills of exchange which were not payable to the

bearer. Although in principle other advantages to alternative assets (portability,

divisibility, recognizability, etc.) could be easily considered in related models,

3 Previouswork thattriestoincorporatesome notionofbanksintosearch-theoreticmodels includes Cavalcanti and Wallace (1999a,b), Cavalcanti et al. (2000), and Williamson (1999). Models that study the interaction among alternative media of exchange, inaddition to the above,includeMatsuyama atal. (1993), Burdettetal. (2001),and Peterson (2002).


and from this one could get a theory of bank notes, we emphasize safety as

the key advantage of bank deposits in the present model and hence think of it

mainly as a theory of checking accounts. 4

The rest of the paper is organized as follows. Section 2 presents the basic

assumptions of the model. Section 3 analyzes the simplest case, where theft

is exogenous, money and goods are indivisible, and we impose 100% reserves.

Section 4 endogenizes theft.

Section 5 considers divisible goods.

Section 6

relaxes the 100% reserves requirement. Section 7 concludes. We cannot in the

interests of space attempt a review of the large literature on banking, almost

all of which is (surprisingly?) pretty far removed from the microfoundations of

monetary economics into which the current paper ¯ts; the interested reader is

referred to the extensive survey by Gorton and Winton (2002).

2 Basic Assumptions

The economy is populated by a [0;1] continuum of in¯nitely-lived agents. Ini-

tially, a fraction M 2 [0;1] of the population are each endowed with one unit

4 It may be useful to de¯ne some terms at this point. A bill of exchange is an order in writing, signed by the person giving it (the drawer), requiring the person to whom it is addressed (the drawee) to pay on demand or at some ¯xed time a given sum of money to

a named person (the payee), or to the bearer. Acheque is a particular, form ofbill, where

a bank is the drawee and it must be payable on demand. Quinn (2002) also refers to bills

as \similar to a modern traveler's check." It is clear that safety was and is a key feature of checks. For one thing, the payee needs to endorse the check, so no one else can cash it withoutcommitting forgery; otherfeaturesinclude the option to \stop" acheckor\cross"it (make it payable only on presentation by a banker). Indeed, the word \check" or \cheque" originallysigni¯ed the counterfoil orindent of an exchequerbill on which wasregistered the detailsoftheprincipal parttoreducetheriskofalteration orforgery;thecheckorcounterfoil partsremained in thehandsofthe banker, theportion given tothecustomerbeingtermed a \drawn note"or\draft." Wealsonoteherethat, whiledeclining, checksarestillthemostcommonmeansofpayment in the US. According to the Philadelphia Inquirer (Feb.14, 2003, p.A1), \There has been a 20% drop in personal and commercial check-writing since the mid 1990s, as credit cards, check cards, debit cards, and online banking services have reduced the need to pay with writtenchecks. [But]Checksarestill king. Thelatestannual ¯guresfromtheFederal Reserve show 30billion electronic transactionsand 40billion checksprocessed in theUnited States." Moreover, \While creditcardsreduce the numberofchecksthat need tobe written in retail stores,the credit-cardbalance still hastobepaid everymonth. And, atleastfornow, thatis usually done by mail {with apapercheck."


of money, which is an object that is consumed or produced by anyone but has

potential use as a means of payment (for simplicity if not historical accurracy,

money here is most easily interpretted as ¯at, although it would not be espe-

cially hard to redo things in terms of commodity money, say following Kiyotaki

and Wright [1989] or Velde et al. [1999]). To begin, in this section we follow the

early literature in the area and assume that goods as well as money are indivisi-

ble and that agents can store at most one unit of money at a time. While there

have been many recent advances in monetary theory that do away with these

restrictive assumptions, there is no doubt that even such simplistic models yield

insights into monetary economics, and they have some advantages in terms of

tractability; hence, we want to study this case ¯rst.

Agents want money not for its own sake but to use as a medium of exchange

in a random matching process where specialized nonstorable goods are traded.

As mentioned above, these goods are indivisible here, but this is relaxed below.

As they are nonstaorable, the goods are produced for immediate trade and

consumption. Trade is di±culy because in the random trading process there

is a standard double coincidence problem: only a fraction x 2 (0;1) of the

population can produce a specialized good that you want. A meeting where

someone can produce what you want is called a single coincidence meeting;

for simplicity, there are no double coincidence meetings, so we can ignore pure

barter, but it would not be hard to relax this. Consuming a specialized good

that you want conveys utility u. Producing a specialized good for someone else

conveys disutility c < u.

Although money is potentially useful as a means of payment, it is unsafe;

it can be stolen. We assume for simplicity that goods cannot be stolen (you

cannot force anyone to produce). Also, because each individual can store at


most one unit of money, only individuals without money steal { so it is truly

money that is the root of all evil here. In each meeting with an agent holding

cash in the exchange process you attempt to steal it with probability ¸, which

is exogenous for now, but this will be endogenized below. Given that you try

to steal it, with probability ° you are successful. Theft has a cost z < u. We

allow for z ¡ c and ° ¡ x to be positive or negative. Thus, crime can be more

or less costly than honest trade, and could be more or less likely to succeed. Of

course, if z · c and ° ¸ x then crime would dominate honest work, since it is

easier and more likely to pay o®, while if c · z and x ¸ ° then honest work

dominates. If z < c and x > °, for instance, there is a trade o® { crime is less

costly by has a lower probability of success.

In general we need to introduce notation to distinguish between di®erent

types of money. The ¯rst type is outside money, the cash that can be stolen.

We assume that the M units of money with which agents are initially endowed

is this unsafe outside money. Each one can, however, potentially deposit his

cash in a bank in exchange for a checking account that is perfectly safe. As

we said above, one way to think of these assets is that they are like traveller's

checks: they are signed by the agent when he gives up his cash, and must be

signed a second time when exchanged for goods; if not endorsed in this way,

the bank is under no obligation to redeem the check for cash. Even if agents

could potentially steal checks, they would be of no value as long as we rule out

forgery. Hence, checks are safe in equilibrium.

Following Lagos and Wright (2002), each period before the random trading

process begins, agents are all together in a centralized location. In this ¯rst

subperiod, say in the morning, agents cannot produce the specialized goods that

will be traded in the random matching market that convenes that afternoon.


However, they can produce and consume a so-called general good, which for

simplicity conveys linear utility (this can be relaxed without di±culty for our


Thus, consuming Q units of general good conveys utility Q and

producing Q units conveys disutility ¡Q. General goods are perfectly divisible,

but they are produced only in the morning and are nonstorable, so that they

cannot be used to trade for special goods in the random matching market that

convenes in the afternoon. Moreover, since afternoon meetings are anonymous

agents cannot trade bilateral promises to exchange specialized goods for general

goods to be delivered next morning. Any interest or fees at the bank will be

settled in terms of general goods.

Later, agents (but not banks) meet in the afternoon market's anonymous

bilateral matching market. Anonymity implies that agents will never surrender

goods without getting something tangible in return (Kocherlakota 1998; Wallace

2001). Hence in this market we must have quid pro quo. In principle, this can

be accomplished with cash or a check, since in practice a check is as good as

cash because banks credibly commit to redeeming the former as long as it has

been signed by the depositor. We simply assume these commitments by banks

are enforced, say by legal authorities, but it is not hard to imagine reputation

playing such a role. In any case, as there may be both inside and outside money

circulating, we let M 0 be the total amount of cash and M 1 the total amount of

cash plus checking deposits.

3 Exogenous Theft

In this section we study the model where stealing is exogenous: if agent i with

money meets agent j without money, j will simply try to rob i with some ¯xed


probability ¸. 5 When j tries to steal i's money, with probability ° he succeeds,

while with probability 1¡° he fails and must leave empty handed. With proba-

bility 1¡¸, j does not try to rob i but rather acts as a \legitimate businessman"

{ which means that, if he can produce a specialized good that i likes, they can

trade. We ¯rst study the case where the only asset is money, which yields a

simple extension of the most basic search model of monetary exchange (e.g.

Kiyotaki and Wright 1993). After studying this case, we introduce banking.

3.1 Money

Throughout the paper we use V 1 to represent the value function of an agent

with 1 unit of money and V 0 the value function of an agent with no money. We

have the °ow Bellman equations

rV 1


(1¡ M)(1 ¡ ¸)x(u+ V 0 ¡ V 1 ) + (1¡ M)¸°(V 0 ¡ V 1 )

rV 0


M(1 ¡ ¸)x(V 1 ¡ V 0 ¡ c) +

M¸°(V 1 ¡ V 0 ¡ z);

where r is the rate of time preference. For example, the ¯rst equation says that

the °ow value to holding money rV 1 is the sum of two terms: the ¯rst is the

probability of meeting someone without money who does not try to rob you

and can produce a good you like, (1 ¡ M)(1 ¡ ¸)x, times the gain from trade

u + V 0 ¡ V 1 ; the second is the probability of meeting someone without money

who robs you, (1 ¡ M)¸°, times the loss V 0 ¡ V 1 .

We are interested in monetary equilibria (there are always nonmonetary

equilibria that are ignored from now on). The incentive condition for agents to

produce in order to acquire money is V 1 ¡V 0 ¡c ¸ 0. Note that we do not impose

the symmetric condition for stealing, V 1 ¡ V 0 ¡ z ¸ 0 since, as we said, theft is

5 One could also assume that a certain fraction of the population always attempt to rob the people they meet with money and the rest never do, but it is slightly easier to assume everyone doessowith some probability.


exogenous for now: with probability ¸ agents cannot help themselves and must

act like criminals. However, do impose participation constraints V 0 ¸ 0 and

V 1 ¸ 0, since we allow agents todrop out of the economy and live in autarky with

a payo® normalized to 0. It is clear from the incentive condition V 1 ¡ V 0 ¡ c ¸ 0

that the binding participation constraint will be V 0 ¸ 0. Hence, a monetary

equilibrium here simply requires that when agents participate and produce in

exchange for money { i.e. that the conditions V 0 ¸ 0 and V 1 ¡ V 0 ¡ c ¸ 0 both


In order to describe the regions of parameter space where these conditions

hold, and hence where a monetary equilibrium exists, de¯ne





(1 ¡ M)(1¡ ¸)xu + M¸°z r + (1¡ M)(1 ¡ ¸)x + ¸°

(1¡ M)[¸° + (1 ¡ ¸)x]u

r + (1¡ M)[¸° + (1¡ ¸)x] ¡


(1 ¡ ¸)x :

Figure 1 depicts C M and C A in (x;c) space using the properties in the following

Lemma (we omit the easy proof).

Lemma 1 (a) x = 0 ) C M =



, C A = ¡1. (b) C M > 0, C A 0 > 0. (c)


C M = C A (x;c) = (x ¤ ;z), where x ¤ =


(1¡M)(1¡¸)(u¡z) .

We can now verify the following.

Proposition 1 Monetary quilibrium exists i® c · minfC M ;C A g.

Proof: Subtracting the Bellman equations and rearranging implies

V m ¡ V 0 = (1 ¡ ¸)x[(1¡ M)u + Mc] + ¸Mz

r + (1¡ ¸)x + ¸


Algebra implies V 1 ¡ V 0 ¡ c ¸ 0 i® c · C M and V 0 ¸ 0 i® c · C A . ¥

Naturally, monetary equilibrium is more likely to exist when c is lower or x


Figure 1: bigger. 6 Also notice that either of the two constraints c · C

Figure 1:

bigger. 6 Also notice that either of the two constraints c · C M and c · C A may

bind. It is easy to see that welfare, as measured by average utility

W = MV 1 + (1 ¡ M)V 0 = M(1¡ M)[(1 ¡ ¸)x(u¡ c) ¡ ¸°z];

is decreasing in ¸ and °. However, the welfare cost of crime here is due to

either the pure resource cost z or the opportunity cost of thieves not producing;

stealing per se is a transfer not an ine±ciency. In any case, when ¸ = 0, so that

C M = C A =


r+(1¡M)x , we essentially have the model in Kiyotaki and Wright


Allowing money to be subject to theft provides an simple but not

unreasonable extension of the basic search-based model of monetary exchange.

We now show it can be used to build a theory of banks.

6 Onemightalsoexpect@C M =@¸<0,butactuallythisistruei®z<z~=


M[r+(1¡M)x)]° ;

thus, for large z, when ¸ increasesagents are more willing to acept money. This is because ¸ measuresnotonly the probability of beingrobbed but alsothe probabilityoftrying torob someone else; when z is very big, if this probability goes up agents are more willing to work for money tokeep themselvesfromcrime. Thise®ectgoesawaywhen ¸isendogenized.


3.2 Banking

We now introduce institutions where agents can make deposits into accounts

on which they can write checks. Checks are safe by assumption: thieves cannot

steal them, or, if they could, checks are redeemable unless signed. 7 In this sec-

tion we assume 100% reserve requirements: a bank simply keeps your money

in its vault and earns revenue by charging a fee Á for this service, paid each

morning in terms of general goods. We assume the banking industry is compet-

itive and banks incur constant cost a to manage each depositor's account. As

a result, Á = a and bank pro¯ts are 0 in equilibrium. Let µ be the probability

an agent with money decides each morning to put his money in the bank (or,

if he already has an account, to not withdraw it). Let M 0 = M(1 ¡ µ) and

M 1 = M 0 + = M. Let V m be the value function of an agent trying to buy

with cash, and V d the value function of an agent with money in his checking

account, exclusive of the fee a. Hence, for an agent with 1 dollar in the morning,

V 1 = maxfV m ;V d ¡ ag.

Although checks will be perfectly safe, it facilitates the discussion for now

to proceed more generally and let ° m and ° d be the probabilities that one can

successfully steal from someone with money and from someone with a checking

account. Bellman's equation for an agent with asset j 2 fm;dg is then 8

rV j = (1 ¡ M)(1 ¡ ¸)x(u+ V 0 ¡ V 1 ) + (1¡ M)¸° j (V 0 ¡ V 1 ) + V 1 ¡ V j :

7 Amodel could have equilibria wherestolen checks, even ifnotredeemable, still circulate asa kind ofbizzare ¯atmoney. We ignore this. 8 The value ofentering the decentralized marketwith assetj is

V j =


1+r [(1¡M)(1¡¸)x(u+V 0 )+(1¡M)¸° j V 0 +³V 1 ]

where ³ = 1¡(1¡M)(1¡¸)x¡(1¡M)¸° j . The ¯rst term is the expected payo® from a trade, the second isthe expected payo® froma theft, and the third is the expected payo® fromleaving the market with an asset worth 1dollar that can be used as cash or deposited nextperiod. Multiplying by 1+r and subtracting V j fromboth sidesyieldsthe equation in the text.


Notice the last term disappears if V 1 = V j ; e.g., if there is no banking this

reduces to the equation for V 1 = V m in the previous section.

without money we have

For an agent

rV 0 = (1¡ ¸)Mx(V 1 ¡ V 0 ¡ c) + ¸[M 0 ° m + (M ¡ M 0 )° d ](V 1 ¡ V 0 ¡ z):

In principle we could allow a thief to steal from a money holder or depositor with

any probability ° m or ° d , but to reduce notation and little loss in generality we

set ° m = ° and ° d = 0.

Bellman's equations can be rewritten

rV m


(1¡ M)(1 ¡ ¸)x(u+ V 0 ¡ V 1 ) + (1¡ M)¸°(V 0 ¡ V 1 ) + V 1 ¡ V m

rV d


(1¡ M)(1 ¡ ¸)x(u+ V 0 ¡ V 1 ) + V 1 ¡ V d

rV 0


(1¡ ¸)Mx(V 1 ¡ V 0 ¡ c) + ¸M 0 °(V 1 ¡ V 0 ¡ z):

We also have V 1 = maxfV m ;V d ¡ ag = µ(V d ¡ a) + (1¡ µ)V m , from which it is

clear that

µ = 1 ) V d ¡ a ¸ V m ; µ = 0 ) V d ¡ a · V m ; and µ 2 (0;1) ) V d ¡ a = V m :

Equilibrium satis¯es this condition, plus the incentive condition for money to

be accepted, V 1 ¡ V 0 ¡ c ¸ 0, and the participation condition, V 0 ¸ 0.

To characterize the parameters for which di®erent types of equilibria exist,


C 1

C 2

C 3




¡ (1¡ M)u



[r + (1 ¡ ¸)x+ ¸°]^a


(1 ¡ ¸)x + M(1¡ M)¸(1 ¡ ¸)°x

(1¡ M)(1 ¡ ¸)xu ¡ ^a

r + (1 ¡ M)(1¡ ¸)x

¡ (1¡ M)u


+ [r + (1¡ ¸)x + (1 ¡ M)¸°]^a

M(1 ¡ M)¸(1 ¡ ¸)°x

where a^ = (1 + r)a. Figure 2 show the situation in (x;c) space for two cases,


z < C 4 and z > C 4 , where

C 4 =


(1 ¡ M)¸° ;

and we assume C 4 < u, or ^a < (1¡ M)¸°u. The following Lemma establishes

that the Figures are drawn correctly by describing the relevant properties of C j ,

and relating them to C M and C A from the case with no banks; again the easy

proof is omitted.

the case with no banks; again the easy proof is omitted. Figure 2: Lemma 2 (a)

Figure 2:

Lemma 2 (a) x = 0 ) C 1 = 1 or ¡1, C 2 = ¡^a=r < 0, C 3 = 1. (b) C 2 > 0,



3 0 < 0, and C 1 is monotone but can be increasing or decreasing. (c) C 1 = C M


(x;c) = (x¹;C 4 ), C 2 = C 3 (x;c) = (x~;C 4 ), and C 1 = C A (x;c) = (x~; C),





^a(r + ¸°) ¡ M(1 ¡ M)¸ 2 ° 2 z

(1 ¡ M)(1¡ ¸)[(1 ¡ M)¸°u ¡ ^a]

^a[r + (1 ¡ M)¸°]


(1 ¡ M)(1¡ ¸)[(1 ¡ M)¸°u ¡ ^a] :



(d) x¹ > x~ z < C 4 < C and x¹ < x~ z > C 4 > C.


We can now prove the following:

Proposition 2 (a) µ = 0 is an equilibrium i® c · min(C M ;C A ;C 1 ). (b) µ = 1

is an equilibrium i® C 3

z < C 4 , c 2 [C 3 ;C 1 ] and

· c · C 2 .

(c) µ 2 (0;1) is an equilibria i® either:


· C 4 ; or z > C 4 , c 2 [C 1 ;C 3 ] and x ¸ x~.

Proof: Consider µ = 0, which implies M 1 = M 0 = M and V 1 = V m . For this

to be an equilibrium we require V m ¡V 0 ¡c ¸ 0 and V 0 ¸ 0, which is true under

exactly the same conditions as in the model with no banks, c · min(C M ;C A ).

However, now we also need to check V m ¸ V d ¡ a so that not going to the bank

is an equilibrium strategy. This holds i® c · C 1 .

Now consider µ = 1, which implies M 0 = 0 and V 1 = V d ¡ a. In this case,

V 1 ¡ V 0 ¡ c ¸ 0 holds i® c · C 2 .

We also need V 0 ¸ 0, but this never binds

since µ = 1 implies rV 0 = M(1¡¸)x(V 1 ¡ V 0 ¡ c) ¸ 0 whenever V 1 ¡V 0 ¡c ¸ 0.

Finally, we need to check

V d ¡ a ¸ V m , which

is true i® c ¸ C 3 .

Finally consider µ 2 (0;1), which implies M 0 = M(1 ¡ µ) 2 (0;M) is en-

dogenous and V 1 = V d ¡ a = V m . The Bellman equations imply

(1+ r)(V d ¡ V m ) = (1 ¡ M)¸°(V 1 ¡ V 0 ):

Inserting V d ¡ V m = a and

V 1 ¡ V 0 =

we can solve for

(1 ¡ ¸)x[(1 ¡ M)u+ Mc]+ M 0 ¸°z r + (1 ¡ ¸)x + (1 ¡ M + M 0 )¸°


M 0 = (1¡M)¸(1¡¸)°x[(1¡M)u+Mc]¡[r+(1¡¸)x+(1¡M)¸°]a^ (C 4 ¡z)(1¡M)¸ 2 ° 2


We need to check M 0 2 (0;M), which is equivalent to µ 2 (0;1). There are two

cases, depending on the sign of the denominator: if z < C 4 then M 0 2 (0;M)

c 2 (C 3 ;C 1 ), and

if z > C 4 then M 0 2 (0;M) i® c 2 (C 1 ;C 3 ). We also need


Figure 3: to check V 1 ¡ V 0 ¡ c ¸ 0, which holds

Figure 3:

to check V 1 ¡ V 0 ¡ c ¸ 0, which holds i® c · C 4 , and V 0 ¸ 0, which holds i®

x ¸ x~.

When x¹ > x~ the binding constraint is c · C 4 , and when x¹ < x~ the

binding constraint is x ¸ x~. ¥

Based on the above results, Figure 3 shows the situation when x¹ and x~ are

in (0;1). 9 In the case z > C 4 , shown in the left panel, we always have a unique

equilibrium, which may entail µ = 0, µ = 1, or µ = © where we use the notation

© for any number in (0;1).

In the case z < C 4 , shown in the right panel, we

may have a unique equilibrium but we may also have multiple equilibria with

µ = 1 and µ = ©, or with all three equilibria. Recall that without banks the

9 The assumption ^a<(1¡M)¸°umentioned above guarantees~x>0,and itiseasy tosee

that¹x>0 i®M(1¡M)¸ 2 ° 2 z<(r+¸°)^a. We alsohave





1 i®^a<¹a=

1 i®^a<~a=

(1¡M) 2 ¸(1¡¸)°u+M(1¡M)¸ 2 ° 2 z


(1¡M) 2 ¸(1¡¸)°u

r+(1¡M)(1¡¸+¸°) :

We donot need x¹and x~in (0;1), butifx~>1, e.g., equilibriawith µ>0 disappear.


monetary equilibrium exists i® c · minfC M ;C A g. Hence, if it exists without

banks monetary equilibrium still exists with banks, and it may or may not

entail µ > 0. However, there are parameters such that there are no monetary

equilibria without banks while there are with banks. In these equilibria we must

have µ > 0, although not necessarily µ = 1. The important economic point is

that for some parameters, and in particular for relatively large x and c, money

cannot work without banking but it can work with it.

Figure 4 shows how the set of equilibria evolves as ^a falls. For very large ^a

banking is not viable, so the only possible equilibrium is µ = 0. As we reduce

a^ two things happen: in the region where there was a monetary equilibrium

without banks, the nature of the equilibrium changes as some or all of the

agents start using checks; and in some regions where there were no monetary

equilibria without banks a monetary equilibrium emerges. As a^ falls further

the region where µ = 0 shrinks. As ^a falls still further we switch from the case

z < C 4 to the case z > C 4 ; thus, for relatively small a^ equilibrium must be

unique, but it could entail µ = 1, µ = 0, or µ = ©.

As ^a falls even further,

eventually there can be no equilibrium with µ = 0, and the only possibility is

that checks will completely drive currency from circulation. Note however that

this is not especially robust: en the next section when we endogenize theft we

will see that banking can never completely drive out money.

An very similar picture of the equilibrium set would emerge if we let M fall,

since reducing M raises the demand for checking services just like reducing ^a.

One reason for this result is the fact that less cash implies a higher demand for

checking because when M is small the number of criminals (1 ¡ M)¸ is big.

However, we can circumvent this by considering what happens when we vary

M and adjust ¸ to keep (1¡ M)¸ constant. The results are shown in Figure 5;


Figure 4: the top row has z > C 4 and the bottom z <

Figure 4:

the top row has z > C 4 and the bottom z < C 4 , and in both rows the left panel

has M smaller than the right panel. Lower M makes µ > 0 more likely, but the

reason now is not that lower M implies more criminals; rather, lower M simply

makes money more valuable, which makes you more willing to pay to keep it

safe. 10

We close this section with a few details.

First, there are other slices of

10 In any case, the results are consistent with the historical evidence that people are more likely tousedemandable debtas meansofpaymentwhen money isin shortsupply (a classic reference isAshton [1945] while a more recentstudyisCuadras-Moratoand Ros¶es[1998]).


Figure 5: parameter space that one could use to illustrate the results; for example, the

Figure 5:

parameter space that one could use to illustrate the results; for example, the

following ¯gure shows the equilibrium set in (z;a) space for progressively larger

values of c, which will be useful for comparison with one of the generalizations

below where c is endogenous. Second, we want to emphasize that equilibria

with µ 2 (0;1) may be considered particularly interesting because they yield

the concurrent circulation of cash and checks. Obviously, the reason cash and

checks may be both used even though they have di®erent rates of return { i.e.,


one has a fee Á = a > 0 and the other does not { is the fact one is safer. In other

words, the model does not display rate of return dominance. Still, we think it

captures something simple but still interesting and historically relevant about


Still, we think it captures something simple but still interesting and historically relevant about banking. Figure

Figure 6:


4 Endogenous Theft

In this section we endogenize the decision to be a thief. 11 One reason is purely

generality, but beyond that the model with ¸ exogenous does have some features

that one may wish to avoid for certain issues (e.g. when M goes down the crime

rate mechanically increases). Moreover, one interesting implication of a model

with ¸ endogenous is that checks can never completely drive currency from

circulation: if no one uses cash, then no one will choose crime, but if there is

no crime then cash is perfectly safe and no one would pay for checks. Hence

it is more likely to have concurrent circulation. So, while many points can be

made with ¸ exogenous, we also want to work things out with ¸ endogenous.

Paralleling the previous section, we start with the case where money is the only

medium of exchange and then introduce banks.

4.1 Money

Let ¸ now be the probability an individual without money chooses to be a

thief at the beginning of each period, given beliefs about the choices of others.

In a symmetric equilibrium, Bellman's equation for V 1 is the same as before,

repeated here for convenience as

rV 1 = (1 ¡ ¸)(1 ¡ M)x(u + V 0 ¡ V 1 ) + ¸(1 ¡ M)°(V 0 ¡ V 1 ):

Bellman's equations for producers and thieves are now

rV p


Mx(V 1 ¡ V p ¡ c) + (1¡ Mx)(V 0 ¡ V p )

rV t


(V 1 ¡ V t ¡ z) + (1 ¡ )(V 0 ¡ V t );

where in this model V 0 = maxfV t ;V p g = (1 ¡ ¸)V p + ¸V t .

11 The basic strategy formodeling crimefollows Burdettetal. (2003).


The equilibrium conditions are

¸ = 1 ) V t ¸ V p , ¸ = 0 ) V t · V p , and ¸ 2 (0;1) ) V t = V p ;

plus the incentive condition V 1 ¡ V 0 ¡ c ¸ 0. Notice that in a model with ¸

endogenous, we do not have to check the participation constraint V 0 ¸ 0: since

an agent can always set ¸ = 0, we have rV 0 ¸ Mx(V 1 ¡ V 0 ¡c), which has to be

non-negative as long as the incentive condition holds. The next observation is

that we can never have an equilibrium with ¸ = 1, since we cannot have agents

accepting money when everyone is a thief: if V 1 ¡ V 0 ¡ c ¸ 0 then

¸ = 1 ) rV 1 = (1¡ M)°(V 0 ¡ V 1 ) · ¡(1 ¡ M)°¹c < 0;

and therefore V 1 ¡ V 0 ¡ c < 0. Hence, we must have ¸ < 1 in any equilibrium.

De¯ne the following thresholds:










(1¡ M)xu

r + (1¡ M)x (x ¡ °)(1 ¡ M)xu+ °(r + x)z x[r + (1 ¡ M)x+ ] [r + Mx+ (1¡ M)°]°z (r + °)x


The next Lemma establishes properties of these thresholds illustrated in Figure

4, shown for the case ° > x ¤ =

(1¡M)(u¡z) (in the other case the region labeled


¸ = © disappears). Again we omit the simple proof.

Lemma 3 (a) x = 0 ) c 0 = 0, c 1 = c 2 = 1. (b) c 0 0 > 0, c 2 0 < 0. (c) c 0 = c 1

(x;c) = (x ¤ ;z) and c 1 = c 2 (x;c) = (°;z). (d) c 0 , c 1 ! u as x ! 1.

We can now establish the following:

Proposition 3 (a) ¸ = 0 is an equilibrium i® either: x < x ¤ and c 2 [0;c 0 ]; or

x > x ¤ and c 2 [0;c 1 ]. (b) ¸ 2 (0;1) is an equilibrium i® x > ° and c 2 [z;c 1 ),

or x < ° and c 2 (c 1 ;z].


Proof: Figure 7: Equilibrium with ¸ = 0 requires V t ¸ V p and


Figure 7:

Equilibrium with ¸ = 0 requires V t

¸ V p and V 1 ¡ V p ¡ c ¸ 0.

Inserting the value functions and simplifying, the former reduces to c · c 1 and

the latter to c · c 0 . Hence, ¸ = 0 is an equilibrium i® c · minfc 0 ;c 1 g, and the

binding constraint will depend on whether x is below or above x ¤ . Equilibrium

with ¸ 2 (0;1) requires V t = V p and V 1 ¡ V 0 ¡ c ¸ 0.

¸ = ¸ ¤ , where

We can solve V t = V p for

¸ ¤ =

(° ¡ x)x[(1 ¡ M)u + Mc] ¡ (r + x)(°z ¡ xc) (° ¡ x)(1¡ M)(xu ¡ xc + °z)


It can be checked that ¸ ¤ 2 (0;1) i® c 2 (c 1 ;c 2 ) when x < ° and ¸ ¤ 2 (0;1)

c 2 (c 2 ;c 1 ) when x > °.

The condition V 1 ¡ V 0 ¡ c ¸ 0 can be seen to hold

c · z when x < ° and i® c ¸ z when x > °.

Hence, ¸ = ¸ ¤ 2 (0;1) is

an equilibrium i® c 2 (c 1 ;z] when x < °, and i® c 2 [z;c 1 ) when x > °.


completes the proof. ¥

As seen in the ¯gure, a monetary equilibrium is again more likely to exist


when c is low or x is high. Given a monetary equilibrium exists, it is more

likely that ¸ = 0 when c is low or x is high, since both of these make honest

production relatively attractive. Given x, it is more likely that ¸ 2 (0;1) when

c is bigger. When x ¤ < ° (e.g., when z is small, as shown in the ¯gure), there

is a region of (x;c) space with x < ° where an equilibrium with ¸ 2 (0;1) exists

and is unique.

Regardless of x ¤ , as long as c 0 > z at x = 1, there exists a

region where equilibrium with ¸ 2 (0;1) and ¸ = 0 coexist. In the case where

¸ 2 (0;1) exists uniquely it has the natural comparative static properties, such

as @¸=@c > 0; in other case things are reversed.

An interesting economic aspect of the results is the following. Notice that

in constructing equilibrium with ¸ 2 (0;1) we need to guarantee that ¸ < 1,

but this condition is actually never binding: for any x, as ¸ increases we hit

the incentive constraint for money to be accepted before we reach ¸ = 1 (when

x < °, we have ¸ < 1 i® c < c 2 while V 1 ¡ V 0 ¡ c ¸ 0 i® c · z; and

when x > °,

¸ < 1 i® c > c 2 while V 1 ¡V 0 ¡c ¸ 0 i® c ¸ z). For example, in the region where

¸ 2 (0;1) exists uniquely, as c increases we get more thieves, but long before

the entire population resorts to crime people stop producing in exchange for

cash and the monetary equilibrium breaks down. In any case, as in the simpler

model with ¸ ¯xed, again the possibility of crime hinders the use of money, and

therefore provides an incentive for agents to ¯nd a safer alternative means of

payment, as we analyze next.

4.2 Banking

With banking, Bellman's equations for V m and V d are

rV m


(1¡ M)(1 ¡ ¸)x(u+ V 0 ¡ V 1 ) + (1¡ M)¸°(V 0 ¡ V 1 ) + V 1 ¡ V m

rV d


(1¡ M)(1 ¡ ¸)x(u+ V 0 ¡ V 1 ) + V 1 ¡ V d ;


and V 1 = maxfV m ;V d ¡ ag. Again V 0 = maxfV p ;V t g, where

rV p


Mx(V 1 ¡ V p ¡ c) + (1 ¡ Mx)(V 0 ¡ V p )

rV t


M 0 °(V 1 ¡ V t ¡ z) + (1 ¡ M 0 °)(V 0 ¡ V t ):

Equilibrium requires the choice of crime to satisfy

¸ = 1 ) V t ¸ V p ; ¸ = 0 ) V t · V p ; and ¸ 2 (0;1) ) V t = V p ;

and the choice of going to the bank satisfy

µ = 1 ) V d ¡ a ¸ V m ; µ = 0 ) V d ¡ a · V m ; and µ 2 (0;1) ) V d ¡ a = V m :

In this section, since things are more complicated, we analyze possible equi-

libria one at a time. In principle, there are nine qualitatively di®erent types of

equilibria, since each endogenous variable ¸ and µ can be 0, 1, or © 2 (0;1), but

we can quickly rule several combinations.

Lemma 4 The only possible equilibria are:

¸ 2 (0;1); and µ 2 (0; 1) and ¸ 2 (0;1).

µ = 0 and ¸ = 0;

µ = 0 and

Proof: Clearly ¸ = 1 cannot be an equilibrium, as then no one accepts

money. If ¸ = 0 then there are no thieves, so money is perfectly safe and we

cannot have µ > 0.

Finally, if µ = 1 then V t = 0 and so we cannot have ¸ > 0

(for generic parameters). This leaves the possibilities listed above. ¥

Proposition 4 µ = 0 and ¸ = 0 is an equilibrium i® x < x ¤ and c 2 [0;c 0 ], or

x > x ¤ and c 2 [0;c 1 ].

Proof: Given ¸ = 0, it is clear that µ = 0 is a best response. Hence the only

conditions we need are V 1 ¡ V 0 ¡ c ¸ 0 and V p ¸ V t .

With µ = 0 these are

equivalent to the conditions from the model with no banks. ¥


Figure 8: To proceed with equilibria where ¸ > 0, de¯ne where A B 0

Figure 8:

To proceed with equilibria where ¸ > 0, de¯ne






C 0

c 11 = ¡B 0 § p B



2A 0


4A 0 C 0


°x 2 [r + (1¡ M)x + ]


¡[(1 ¡ M)°xu + (x ¡ °)^a](x ¡ °)x ¡ [2(r + x) ¡ M(x ¡ °)]° 2 xz


(x ¡ °) 2 xu^a + [(1 ¡ M)°xu+ (x¡

°)a^](x ¡ °)°z + (r


x)° 3 z 2 :

The function c 11 is shown in Figure 8 for both positive and negative values of x,

even thoug x < 1 makes no economic sense. As the solution to a quadratic, c 11

generically takes on 2 or 0 values. Notice that c + 11 ! 1 as x ! ¡ r+M° from


below, and c ¡ 11 ! ¡1 as x ! ¡ r+M° from above. Also, (c +


11 ;c ¡

11 ) ! (¡1;¡1)

as x ! 0 from below, and (c +

11 ;c ¡

11 ) ! (1;1) as x ! 0 from above.


(c 11 + ;c 11 ¡ ) ! ³

°(1¡M) ;u ´ as x ! §1, where the ¯gure is drawn assuming


a^ < u°(1 ¡ M).

Finally, notice in the ¯gure that there is a region of (0;1)

where there is no solution; this is true for big ^a, but for smaller a^ this region

disappears and there are two solutions for all x 2 (0;1).


Figure 9: This is seen more clearly in Figure 9, which shows c 1 1

Figure 9:

This is seen more clearly in Figure 9, which shows c 11 as well as c 0 and c 1

for x 2 [0;1] and c 2 [0;u].

In the left panel, drawn for large a^, c 11 does not

exist in the neighborhood of x = ° (for still bigger ^a, c 11 would not even appear

in the ¯gure). As ^a shrinks, c 11 exists for more values of x, and at some point

it does exist in a neighborhood of x = ° as in the middle panel. As ^a shrinks

further, c 11 exists for all x > 0, as in the right panel. One can also show the

following, again assuming u > lim x!1 c ¡

11 =


°(1¡M ) (the other case is similar).

Lemma 5 (a) for x > °, if c 11 exists then c 11 + < c 1 ; for x < °, if c 11 exists

then c 1 < c ¡

11 ;

if c 11 exists in the neighborhood of x = ° then c 11 = c 1 at

(x;c) = (°;z). (b) for x > °, c + 11 ! c 1 as ^a ! 0; for x < °, c 11

¡ ! c 1 as ^a ! 0.

Based on these results, we have the following.

Proposition 5 µ = 0 and ¸ 2 (0;1) is an equilibrium i® either: x > °, c 2

[z;c 1 ), and c 2= (c ¡


;c +

11 ); or x < °, c 2 (c 1 ;z], and c 2= (c ¡


;c 11 + ).

Proof: In this case the conditions for ¸ 2