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A Dynamic Model of the Payment System∗ Thorsten Koeppl Cyril Monnet Queen’s University Federal Reserve Bank of Philadelphia Kingston, Ontario Philadelphia, PA thor@qed.econ.queensu.ca Cyril.Monnet@phil.frb.org Ted Temzelides University of Pittsburgh Pittsburgh, PA 15260 tedt@pitt.edu August 4, 2007 ∗We thank audiences at CEMFI, The Central Bank of Portugal, Cornell, the Federal Reserve Banks of Cleveland and New York, the European Central Bank, Penn, Rice, Wharton, the Vienna Workshop in Macroeconomics, the North American Summer Meetings of the Econometric Society as well as Aleks Berentsen and Borghan Nezami Narajabad for comments and suggestions. The views expressed in the paper are not necessarily those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. The first and third author gratefully acknowledge support from SSHRC and the NSF through grants 410-2006-0481 and SES 0517862, respectively. 1 Abstract We study the design of efficient intertemporal payment arrangements when the ability of agents to perform certain welfare-improving transactions is subject to random and unob- servable shocks. Efficiency is achieved via a payment system that assigns balances to par- ticipants, adjusts them based on the histories of transactions, and periodically resets them through settlement. Our analysis addresses two key issues in the design of actual payment systems. First, effi