PROFESSORIAL FELLOWSHIP. MONEY, LIQUIDITY, AND THE AGGREGATE ECONOMY.

With Nobuhiro Kiyotaki (LSE), I have recently developed a simple framework for thinking about money and liquidity. This research builds on work I have done with Oliver Hart (Harvard) on control rights in financial contracts.

The framework now needs to be put to use, to address questions that are fundamental both to macroeconomic theory and to policy making. Why does the degree of liquidity of certain assets vary through the business cycle? What explains the so-called flight to quality? Through what channels do central banks affect aggregate activity, and why are they effective at all? What happens to their role if fiat money disappears from use; can they still act as lender of last resort? Is the feedback from asset prices to aggregate activity through balance-sheets pernicious, or part of the economy's efficient response? What causes financial crises, and when should central banks intervene, if at all? Might financial instability paradoxically be more severe when there is monetary stability (as at present)? Why are financial contracts so incomplete, in the sense that debt is insufficiently indexed to the price of collateral, or, more generally, that borrowers are inadequately insured by their creditors? Are there inefficiencies here, that might be overcome through judicious regulation or policies to switch to more imaginative standard-form contracts such as "dequity" (that is, a financial contract having the control rights of debt, but having the return stream of equity).

Many of these questions can be addressed in extensions of the new framework I have developed with Kiyotaki. But to answer some of the questions, further work is needed on the foundations of contractual incompleteness, which I will be undertaking with Oliver Hart.

I have undertaken two principal lines of enquiry, in collaboration with Professor
Nobuhiro Kiyotaki of Princeton University, and Professor Oliver Hart of Harvard
University. With Kiyotaki, I have worked on macroeconomic questions to do with
the nature of money and liquidity, and the interplay between the financial system and the aggregate economy. With Hart, I have explored the foundations of contractual incompleteness, and the economics of power and control.
Kiyotaki and I define inside money very broadly as any privately-issued long-term paper that is held by a number of agents in succession. Whenever paper circulates as a means of short-term saving (liquidity), it can properly be considered as money, or a medium of exchange, because agents hold it not for its maturity value but for its exchange value. We construct a model of an economy in which agents borrow by issuing long-term paper, and use the model to ask: When and why is circulation of the paper essential to the smooth running of the economy? If there is a shortage of liquidity, what are the symptoms? Does the economy respond efficiently?
We draw a distinction between two aspects of financial contracting: bilateral
commitment versus multilateral commitment. On the one hand, there may be a limit on how much a private agent can credibly promise to repay someone who provides finance: i.e., the degree of bilateral commitment a borrower can make to an initial lender when selling a paper claim. On the other hand, there may be a limit on the extent to which the initial lender can resell the paper to someone else in a secondary market: in effect, the degree of multilateral commitment the borrower can make to repay any bearer of the claim.
Economists have long held the view that the development of the financial system (financial deepening) and economic development are closely intertwined. Kiyotaki and I use our distinction between bilateral commitment and multilateral commitment to develop a model of financial deepening. We explore the effects of secular changes in financial depth on investment and output; on intermediation and interest rates; on the long-run velocities of circulation of different monetary instruments and the use of
outside money; and on the patterns of saving and trade in paper. Our theory allows us to trace the evolution of different kinds of money, from ancient to modern. The framework can also be used to examine shorter-term fluctuations. Kiyotaki and I construct a business cycle model with an essential role for money, that allows us to examine the interaction between the circulation of monetary assets, monetary policy, resource allocation, and asset prices.