Interest-bearing money and banking in a news economy

Abstract

Abstract Private currencies can facilitate intertemporal exchange under limited commitment but exhibit excessive volatility when backed by productive assets subject to news shocks. I develop a model where banks issue deposits backed by firms’ output as collateral, with deposits circulating as currency. Adverse news about firm productivity—even when socially uninformative—induces binding debt constraints and deposit volatility, creating liquidity shortages that depress economic activity. With household heterogeneity, deposits are priced at a premium in liquidity-constrained economies. Interest-bearing central bank money provides an additional policy tool beyond traditional money growth. The interest rate influences asset prices through an investment channel: banks hold interest-bearing reserves as insurance against productivity shocks. This enables welfare-improving policies requiring positive inflation and nominal interest rates—departing from the Friedman rule. Calibrating the model to the US economy, I find that interest-bearing money generates a welfare gain of 2.54%, with the welfare cost of departing from the Friedman rule being roughly an order of magnitude smaller than the cost of operating with a suboptimal transfer. As an extension, I examine private information about consumer preferences, showing that illiquid bonds become essential for achieving efficiency. Cash-in-advance constraints on deposits can improve welfare by preventing destabilizing arbitrage, enabling coexistence of government and private currencies.