As Good as Gold? A Framework for Analyzing Redeemable Paper Money
In this paper we present a theory of note discounts, exchange rates between brands of notes, and the price level in convertible paper money regimes. We show that under perfect commitment to convertibility, notes and the underlying commodity are perfect substitutes and price level determination is identical to a pure commodity standard. Different brands of currency trade at par. With imperfect commitment to convertibility, the probability that the issuer reneges on the commitment to convertibility explains discounts/premia on notes and exchange rates between brands in competitive note regimes. In non-competitive regimes, the probability of reneging explains fluctuations in the price level. To support our model, we discuss historical events and time periods that are consistent with our theory.