Understanding Financial Crises

By Franklin Allen; Douglas Gale | Go to book overview

8
Money and prices

In the preceding chapters, we have assumed that intermediaries offer depositors [real] contracts, that is, contracts that are denominated in terms of goods. For example, an intermediary offers its depositors a deposit contract that promises q units of the good if the depositor withdraws at date 1 and c2 units of the good if the depositor withdraws at date 2. In practice, the terms of deposit contracts and debt contracts in general are written in [nominal] terms, that is, they specify payments in terms of money. Economists often justify the substitution of [real] for [nominal] contracts by claiming that money is a [veil] that hides the reality we are interested in, namely, the goods and services that firms produce and individuals consume; but the fact that contracts are written in terms of money has some important implications that are not captured by [real] models. The most important feature of nominal contracts is that changes in the price level (the general level of prices measured in terms of money) change the real value of the contract.

A. C. Pigou was one of the first to point out the impact of the price level on the real value of debt. More precisely, outside money, the part of the money supply that constitutes a claim on the government, represents part of the private sector's net wealth. A fall in the price level by definition increases the real value of outside money and, consequently, increases the private sector's real wealth, that is, its wealth measured in terms of goods and services. This [wealth effect] subsequently came to be known as the [Pigou effect.] Pigou used it to criticize Keynes' argument that a general fall in prices would have no effect on demand for goods and services. Keynes relied on the familiar homogeneity property of demand functions: because demand and supply depend only on relative prices, an equal proportionate change in prices and wages should have no effect on demand and supply. Pigou argued to the contrary that a fall in the general level of prices would increase perceived wealth and that this might lead consumers to demand more goods and services.

An important element of Pigou's argument was the distinction between inside and outside money. Outside money consists of currency and deposits with the Federal Reserve System, sometimes called the monetary base or highpowered money. Inside money consists of bank deposits and other liabilities of

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Understanding Financial Crises
Table of contents

Table of contents

  • Title Page iii
  • Preface v
  • Contents vii
  • 1: History and Institutions 1
  • 2: Time, Uncertainty, and Liquidity 27
  • 3: Intermediation and Crises 58
  • 4: Asset Markets 99
  • 5: Financial Fragility 126
  • 6: Intermediation and Markets 153
  • 7: Optimal Regulation 190
  • 8: Money and Prices 216
  • 9: Bubbles and Crises 235
  • 10: Contagion 260
  • Index 299
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