2. Lecture 3 The Microfoundations of Money - Part 2

3. 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

4. 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

5. 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

6. Overlapping Generations Model (OLG)

10. An example

11. Consumption of the existing old

12. Autarky-no trade (M=0)

13. Monetary equilibrium (M 0 but no saving)

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

15. 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

16. 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

17. Money in the Indirect Utility Function (MIIUF)

19. 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.

20. C-I-A continued

21. 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.

22. Townsends 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}.

23. 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

24. Monetary existence 0 1 2 M Goods

25. 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.

26. 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

27. 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.

28. 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.

29. 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