In chapter 6 it was argued that trade with intermediate exchange of goods is a costly and burdensome way of conducting transactions. Chapter 7 introduced privately issued I.O.U.s as a rudimentary financial transaction technology. Rather than exchanging goods themselves, debt claims written on those goods could be exchanged and the cost of intermediate exchange could be saved. One key problem with privately issued I.O.U.s was asymmetric information about the ability of a debtor to repay her debt. To rule out moral hazard it was necessary to establish an incentive structure relying on penalties which had to be imposed even if agents were truly unable to repay their debt. Because these incentive costs were sharply rising in the share of the endowment which an agent decided to securitize as an I.O.U., trading volumes got depressed. Traders decided to issue I.O.U.s only on part of their endowment. Hence a private decentralized creation of I.O.U.s as a medium of exchange led to an underprovision of this medium. Benefits from trade between agents could not be fully exhausted. Once these I.O.U.s had been issued, however, they performed well the function of a medium of exchange. In the secondary market between traders of type B and D the I.O.U.s issued by traders of type A and C were easily tradable due to their credible, incentive compatible structure. Hence the major problem to be addressed is how to reduce the cost of credibly issuing I.O.U.s.
KeywordsCentral Bank Equilibrium Price Equilibrium Path External Market Sequential Equilibrium
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