Issuing Asset-Backed Money with Transparency: Monopoly versus Competition

Abstract

I study the efficiency of issuing asset-backed money by comparing a competitive setting with a monopoly. In the model a money supplier can issue money by holding commodity such as gold, but they can also fake the quality of commodity at a proportional cost. There arises a haircut in the value of money transactions, when the moral hazard incentive becomes severe. Under perfect competition the decentralized issuers would provide money until the rates of return in money and gold are equal in equilibrium. This competitive equilibrium can be sub-optimal, because the individual issuers do not internalize the aggregate supply effect of issuing money on the prices and the haircut in general equilibrium. When the cost of faking assets is sufficiently small, the monopoly equilibrium is more efficient than the competitive equilibrium. Despite an inefficiency associated with the monopoly rent, the monopoly issuer can adjust the supply of money by considering the effects on the prices to reduce its own moral hazard incentive to raise the pledgeability of money and maximize the profit. Imposing a pigouvian tax and/or an entry cost can improve welfare of the competitive equilibrium by raising the transparency on the issuer’s moral hazard.