Beyond the central bank: a formal approach to free banking theory

Abstract

This paper develops a parsimonious model of bank behavior under a free banking regime, where the issuance of inside money is not centrally managed but instead governed by market forces. Building on a partial equilibrium framework influenced by Selgins work on Free Banking Theory, I show that a profit-maximizing bank will endogenously limit the issuance of demandable liabilities due to rising liquidity costs associated with reserve depletion. This result provides a microeconomic foundation for the theory of monetary equilibrium, whereby the supply of inside money adjusts to match demand (Sm = Dm). At the macro level, I explore the implications of this equilibrium condition for the price level and the natural interest rate, arguing that a free banking system can achieve monetary stability without central intervention. While the model abstracts from frictions such as coordination failures or asymmetric information, it offers a tractable foundation for understanding self-regulation in competitive banking environments. The findings challenge conventional views that associate free banking with monetary instability, and suggest that under certain conditions, decentralized banking can deliver disciplined and efficient outcomes.