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Lecture 3

Lecture 3. The Microfoundations of Money - Part 2. Dissatisfaction with ad hoc formulation and MIUF approach OLG - a theory of monetary exchange under Laissez Faire Critical evaluation of OLG - purely a store of value Intergenerational contracts Legal restrictions

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Lecture 3

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  1. Lecture 3 The Microfoundations of Money - Part 2

  2. Dissatisfaction with ad hoc formulation and MIUF approach • OLG - a theory of monetary exchange under Laissez Faire • Critical evaluation of OLG - purely a store of value • Intergenerational contracts • Legal restrictions • Another look at MIUF and CIA

  3. Fiat money economy • Must satisfy two conditions • 1) Inconvertibility • 2) Intrinsic uselessness • According to Wallace if the 2 conditions are taken seriously, then for a monetary theory to develop there are 3 options

  4. Fiat Money Theory • 1. Abandon the conditions of inconvertibility and intrinsic uselessness • 2. Impose legal restrictions to give money value • 3. Model the notion that fiat money facilitates exchange

  5. Overlapping Generations Model (OLG)

  6. An example

  7. Consumption of the existing old

  8. Autarky-no trade (M=0)

  9. Monetary equilibrium (M0 but no saving)

  10. Monetary equilibrium (M0) • Notice that with no inflation Pt+1 = Pt and Y > γY • If inflation increases Pt+1 > Pt then the upper budget line swings down. • When Pt/Pt+1 = γ, the young are indifferent between storing their output and receiving money from the old. Y(P/Pt+1)

  11. Critique • Ignores medium of exchange function • does not explain, why store of value function is not dominated by contracts • But Wallace says that medium of exchange occurs inter-generationally • McCallum says that an economy with a medium of exchange is more efficient than one without

  12. Store of Value • Any monetary model must face the following problems • 1. Possible dominance of money by contracts • 2. Segniorage • 3. Terminal value of money

  13. Money in the Indirect Utility Function (MIIUF)

  14. Cash - in - Advance • The cash in advance constraint is intended as a formal representation of the transactions demand for money. Baumol (1952) for example makes the implicit assumption that money is required for transactions and add a cost of ‘going to the bank’.

  15. C-I-A continued

  16. C-I-A • One of the criticisms of this model is that it implies a demand for money that is insensitive to the rate of interest and also has a unit income elasticity of demand for money.

  17. Townsend’s Spatial Separation Model • There are an infinity of infinitely lived agents • In each period household ‘i’ has an endowment ‘m’ but because of spatial separation is physically able to contact only adjacent households {i-1} and {i+1}. • Tastes of household {I} are such that it desires goods from {i} and {i+1}.

  18. Turnpike Model • Household {i+1} desires goods from itself {i+1} and {i+2}. • Households cannot make bilateral IOU arrangements because there is nothing that household {i-1} can offer {i} and nothing that {i} can offer {i+1} • So barter is impossible

  19. Monetary existence Goods M 0 2 1

  20. Why is it that money and default-free interest bearing securities co-exist • Suppose government issues risk-free small denomination bearer bills. • If the bills co-existed with cash, would they sell at a discount or at par? • If sold at a discount, consider at a date close to maturity everyone would prefer bills to cash. • By repeated argument that means no one will ever hold cash.

  21. Co-existence • If bills co-exist then they must always sell at par - i.e. no interest. • But since we know that bills sell at a discount, co-existence occurs because: • bills are non-negotiable • large denominations • represents a legal restriction • The different yields on cash and bills is a LR

  22. Legal Restrictions Theory of Money • Prediction of legal restrictions theory: • non-interest bearing paper currency should not co-exist with risk-free small denomination interest-bearing securities in the absence of legal restrictions.

  23. Historical evidence • Makinen & Woodward - JPE (1986) - provide evidence to show that small denomination French government issued bearer bonds in pre-revolution France, failed to circulate as a medium of exchange • White JMCB (1987) - free banking period 1716-1844 (Scotland) paper money circulated with interest-bearing promissory notes, redeemable on demand.

  24. Question? • Economists continue to ask the question: • A monetary economy clearly works ‘in practice’ • But does it work ‘in theory’ • The answers are not entirely satisfactory

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