Working Paper 641

A Model of Banknote Discounts

Warren E. Weber | Retired Economist
Francesca Carapella
Pricila Maziero
Laurence Ales

Revised March 1, 2006

Prior to 1863, state-chartered banks in the United States issued notes–dollar-denominated promises to pay specie to the bearer on demand. Although these notes circulated at par locally, they usually were quoted at a discount outside the local area. These discounts varied by both the location of the bank and the location where the discount was being quoted. Further, these discounts were asymmetric across locations, meaning that the discounts quoted in location A on the notes of banks in location B generally differed from the discounts quoted in location B on the notes of banks in location A. Also, discounts generally increased when banks suspended payments on their notes. In this paper we construct a random matching model to qualitatively match these facts about banknote discounts. To attempt to account for locational differences, the model has agents that come from two distinct locations. Each location also has bankers that can issue notes. Banknotes are accepted in exchange because banks are required to produce when a banknote is presented for redemption and their past actions are public information. Overall, the model delivers predictions consistent with the behavior of discounts.

Published In: Journal of Economic Theory (Vol. 142, No. 1, September 2008, pp. 5-27)

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