The I-Theory of Money

A theory of money needs a proper place for financial intermediaries. Intermediaries create inside money and their ability to take risks determines the money multiplier. In downturns, intermediaries shrink their lending activity and fire-sell assets. Moreover, they create less inside money, exactly at a time when the demand for money rises. The resulting Fisher disinflation hurts intermediaries and other borrowers. The initial shock is amplified, volatility spikes and risk premia rise. Monetary policy is redistributive. An accommodative monetary policy, focused on the assets held by constrained agents, recapitalizes balance sheet-impaired sectors in downturns and hence mitigates these destabilizing adverse feedback effects. However, monetary policy also creates moral hazard in the sense that it cannot provide insurance and control risk-taking separately. Hence, macroprudential policy that controls leverage attains higher welfare than monetary policy alone.