Breaking the Curse of Cash

Abstract

Can eliminating large denomination bills improve social welfare? We construct a dual currency model to study whether illegal activity can be reduced or eliminated by modifying the payment environment. In our model, there are two types of money, (small bills) and (large bills) and two types of goods, legal and illegal. Legal (goods) traders are ex ante indifferent between coins and paper money, but illegal (goods) traders face a lower transaction cost of using paper money in comparison to coins because illegal trade is easier to conceal. Eliminating paper money can reduce illegal trade and the social cost associated with illegal activity. However, this pooling equilibrium is suboptimal because the government can collect more seigniorage by allowing illegal traders to use paper money with a lower rate of return. When the transaction cost of using coins for illegal traders is sufficiently large, a separating equilibrium, where legal traders use coins and illegal traders use paper money, can maximize welfare by making an implicit transfer from the illegal traders to the legal traders. In short, an optimal monetary policy is a sort of Pigouvian policy in which the monetary authority engineers a transfer from illegal traders to legal traders.