LIQUIDITY CREATION, EFFICIENCY, AND FREE BANKING

I explore the functioning of inside money competition in an overlappin g generations model to address the question of whether the base of cur rency supply should be a monopoly. In such an economy, banks enhance a llocative efficiency by offering short-term contracts (banknotes) in o rder to finance long-term investments since wealth has to be transferr ed between the generations prior to the fruition of the high-yielding long-term investments. Liquidity is created by offering agents favor a ble short-term contracts for funds that are earmarked for long-term in vestments. I study how issuance of banknotes, liquidity creation, and payment processes interact in competitive and monopolistic banking ind ustries. I show that neither free banking (banking with free entry) no r monopoly banking achieves a first-best (Pareto-efficient) allocation . However, free banking is Pareto-inefficient compared to monopoly ban king. This inefficiency arises from the overissuance incentives of com peting banks. Additional liquidity needs are distributed among all ban ks through the payment system provided that households are indifferent to which banknotes they use to satisfy their liquidity needs. Hence, the issuer of banknotes creates a negative externality since other ban ks must invest more in short-term investments in order to balance liqu idity needs. Under free banking, the first holders of banknotes receiv e an implicit return, so they can profit from funds earmarked for long -term investments. The monopoly does not provide implicit returns, but the first holders get returns from their banks' shares. Monopoly bank ing Pareto-dominates free banking since it has to devote a smaller por tion of resources to less profitable shortterm investments. (C) 1998 A cademic Press.