Economics 302 - Macroecononomic Theory II

Winter 2011
Jean-Paul Lam
Lecture 4
Money

1 Introduction

Monetary economics is concerned with the effects of monetary institutions and policy actions on
important economic variables such as inflation, output, interest rates, unemployment, commodity
prices, etc. The study of monetary economics as a special field is important as money, although
one of many commodities, plays a special role in the economy. Money (fiat money) facilitates
transaction between different parties. Moreover, monetary policy and decisions by central banks
has an overwhelmingly impact on the economic life of a nation (good or bad). Some of the basic
questions we will try to answer in this lecture are: what is the nature and functions of money?
why is money important and why do people want to hold money? In this lecture, we will provide
a definition of money and show how the existence of money facilitates transactions and reduces
search and transaction costs by solving the double coincidence of wants problem. We begin this
lecture by defining what money is and what its functions are.

2 Definitions and functions of money

What is money?
Money is usually a commodity (worthless) that can be used to purchase goods and service or
an asset. It is generally accepted as a means of payment. For example, coins, banknotes, cheques
written, e-money, plastic cards, travellers cheques and so on. Typically a commodity should possess
the following characteristics before being used as money: durable, easily transportable, divisible in
small parts, units of standard value and worthless as a commodity.
Money serves three main functions:

1. Medium of exchange

2. Medium of account

3. Store of value

3 Money as a Medium of Account

Money as a medium of account facilitates transactions by simplifying the calculation of relative

prices. Define the relative price (real price) as the ratio at which exchanges can take place for each
pair of goods. For example, the relative price of good X in terms of good Y is the number of units
of Y that will be exchanged for a unit of good X.

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 If an economy has J distinct commodities, there are J(J−1)
2 different relative prices denoting the
ratios at which exchanges can be made for each pair of goods.
For example assume three goods:

• J1 = pears

• J2 = oranges

• J3 = apples

Then we need to know only three prices to tell us how to exchange one good for another.

• p1 = number of units of pears required to buy 1 apple

• p2 = number of units of pears required to buy 1 orange

• p3 = number of units of apples required to buy 1 orange

This is easy with 3 goods but imagine an economy with thousands or millions of goods. For
example if J = 100, 000, the number of relative prices is 100000∗99999
2 = 499, 950, 000. A very large
number to remember if we don’t have a common medium of account (imagine the supermarket
cashier trying to figure out the relative price of a good with such a system).
Not having one common numeraire can make the calculation of relative prices confusing when
performing transactions. Money usually serves as the common numeraire or medium of account
and thus reduces the complexity of transaction. All the other goods can be expressed in terms of
that numeraire, in our case money.
In fact, there is a strong tendency for the medium of exchange to be used as the only medium of
account (or numeraire). Since money is the common medium of exchange in a monetary economy,
therefore (relative) prices are quoted in terms of money.
In our case, if we have money as the numeraire and medium of account, if we have J = 100, 000
commodities, we can express the prices of each of the other 99,999 commodities in terms of money.
In this case knowledge of the 99,999 money prices is all that is needed or useful for transactions
(compared to 499,950,000 in the barter economy).
Hence if we have J commodities goods where J = 1, 2, 3....j where j is money, then the relative
price of goods J = 1, 2, 3..., j is simply:
p1
P1 = (1)
pj
p2
P2 = (2)
pj
..
. (3)
pj
Pj = = =1 (4)
pj

Hence pj is the number of units of money that must be given up in order to acquire one unit of
a given good. Thus, the value of money is simply the inverse of the price level.
Note that if everyone in the market could be fully trusted, all exchanges could be based on credit
and with multilateral credit and a complete set of markets, money would not be needed. However,

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because of asymmetric information, uncertainty and the unwillingness of traders to extend credit,
money is required as a means of payment. Clower (1971) has labelled this as a liquidity or cash-
in-advance constraint.

3.1 Money as a Store of Value

Money, as a store of value, is a way to transfer purchasing power from the present to the future.
Money is a store of value since it enables individuals to transfer wealth across different genrations.
If somebody wishes to save part of its current income for use at a future date, she can acquire
money and hold it. There are many other assets or commodities that serves as a store of value
(bonds, stocks, commodities). These store of value are typically better than money. Money is a
poor store of value for many reasons. It does not pay any interest, that is the opportunity costs
of holding money is the interest rate that someone forgoes on a bond for example, and its value is
quickly eroded by increases in the price level, that is when the price level increases, its value falls.
This is why individuals usually hold less money when the price level is rising. In extreme cases, if
the price level is rising very rapidly (hyperinflation), money can cease to be a store of value.

4 Money as Medium of exchange

The medium of exchange function of money is the most important function of money. To under-
stand the medium of exchange function, consider two possible economies: a barter economy where
individuals exchange goods (or commodities) for goods (or commodities) and a monetary economy
where there exists a certain durable and transportable commodity that is generally acceptable in
exchange for any other good or service which we can call money. At this stage, we do not care
whether money takes the form of a commodity or simply is fiat money.
For barter to operate, double coincidence of wants must prevail (if I want an ipod and I have
a Blackberry in exchange, I must find somebody who not only has a Blackberry but also wants
an ipod in exchange). For economies, that have a small amount of goods and services, this trade
arrangement does not present many challenges and problems. However, for large economies, trade
arrangements in a barter economy can be very inefficient as individuals are forced to spend a large
amount of their time and resources in the activity of searching for suitable partners for trade. Put
simply, the opportunity cost of a system of exchange by barter is very high.1
On the other hand, in a monetary economy, money facilitates transactions since individuals can
use money to perform transactions without engaging in a lengthy and costly search process. This
is because in a monetary economy, the need for the double coincidence of wants is eliminated. In
a monetary economy, the single transaction of a barter economy can be decomposed into several
transactions of sale and purchases. Moreover, the split into separate transactions not only imply
the separation of wants but also the separation of transactions in time. The use of money as a
medium of exchange implies a smaller amount of resources (in terms of search) and hence a lower
social cost.
1
The literature usually distinguishes between two types of barter: (i) fairground barter where a fair at a specific
location, time and date is held for the exchange of goods and (ii) trading post barter where an individual would set
up a trading post where goods and services could be exchanged.

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 As an example consider the following two hypothetical economies J different types of goods.
We start with a very simple example and assume that J = 3, that is there are three commodities:
(a, b, c). In the barter economy, trade occurs by exchanging goods. In Table 1 below x represents
permissible exchanges while o represents non-permissible exchanges

Table 1: Exchanges in a Barter Economy

a b c
a o x x
b x o x
c x x o

For example, good a can be exchanged for good b and c. Given this information, we can calculate
the probability on any given attempt that someone is going to make a successful exchange under
the barter economy. Recall that under the barter system, the need for double coincidence of wants
must prevail. I need to meet someone who not only has what I want but also needs what I have.
It is clear from table 1, that the number of possible exchanges with 3 goods is simply J 2 −J = 6.
Hence, the probability of finding a match where the double coincidence of want is satisfied is simply
1
(J 2 −J) . If J is large, as we should expect in a modern economy, then the probability of making a
successful exchange becomes very small.
For example, if J = 1000000, then in a barter economy, the probability of finding the right
match is simply (100000021−1000000) = 1.0e−12 , indeed a very small number. In other words, the
average number of attempts before finding a double coincidence of wants is J 2 − J, the inverse of
the probability of success on any single try. If we assume that there is a search cost µ, then this
search cost under a barter economy is simply µ(J 2 − J).
On the other hand, in a monetary economy, since goods cannot be exchanged for other goods
and assuming no transaction costs and good a is money, we have the following:

Table 2: Exchanges in a Monetary Economy

Ca Cb Cc
Ca o x x
Cb o o o
Cc o o o

We will assume for now that the money we are talking about is imply fiat money. If there are
J = 3 goods, it is clear that the number of possible exchanges is given by J − 1 = 2, that is money
can be used (good a) to buy good b and/or good c. If J is a large number, we can approximate the
number of possible to be simply J. Hence in this case, the probability of finding what you need in
exchange for money will be simply J1 . This probability is unambiguously less than the probability
of success under the barter economy. Hence with money, it takes on average J searches to find a
successful trade. If we again assume that there is a search cost µ, then this search cost under a
monetary economy is simply µJ and this is less than the search cost under a barter economy which
was given by µ(J 2 − J) when J > 2.
The medium of exchange function is generally regarded as the distinguishing function of money.
It is to be noted that the saving in time and energy provided the medium of exchange—money—

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does not depend on whether that commodity has value or not. The only requirement is that it is
acceptable as a medium of exchange.
The second feature of money as a medium of exchange is that is facilitates transactions and
in some cases make transactions possible. To illustrate this point, we will use an overlapping
generations model (OLG). The overlapping generations model will show how the existence of money,
as a medium of exchange, improves welfare and facilitates trade. we first begin by laying out the
assumptions of our model.

5 An Overlapping Generations Model

In the OLG model, individuals live for two periods. In period 1, they are born and are described
as being young, whereas in the second period, they become old and die at the end of that period.
We refer to those in the second period of their life as old.2
The economy begins in period 1. In each period t ≥ 1, Nt individuals are born, where time is
index by the subscript t. Thus in period 1, N1 individuals are born, in period 2, N2 individuals
are born, and so on. The economy begins in period 1 with N0 members of the initial old. The
individuals born in period 1,2,3,.... are called the future generations of the economy.
Hence in each period t, there are Nt young individuals and Nt−1 old individuals. For example
in period 2, there will be N2 young individuals and N1 old individuals, that is those who were born
in period 1 and who are now old in period 2. For simplicity, we assume that there is only one good
in this economy and the good is homogeneous. More importantly, the good is perishable and thus
cannot be stored from one period to another.
In the basic set-up, each individual receives an endowment of the consumption good in the first
period of life and this amount is denoted by y. You can also interpret this endowment as labour.
The individual uses this labour endowment and earn income y. Individuals when old, that is when
they are in their second period of their life receives no endowment.
The pattern of endowments is illustrated in Figure 1. In period t, generation t is born. Each
individual lives for two periods and individuals are endowed with y when young and 0 units when
old. In any given period, there is one generation of young people and one generation of old people.

Table 3: Pattern of endowments in the OLG model

Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Period 7
Generation 0 0
Generation 1 y 0
Generation 2 y 0
Generation 3 y 0
Generation 4 y 0
Generation 5 y 0
Generation 6 y 0

5.1 Preferences
2
One of the strengths of the OLG model is that it is highly tractable and easy to use.

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Members of future generations in the OLG model consume both when young and when old. An
individual’s utility therefore will depend of how much she consumes when young and when old. We
make the following assumptions about the individual’s preferences about consumption:

• The individual’s utility is higher if she can consume in both periods rather than in only a
single period. In other words, the individual prefers to smooth consumption over time and
does not want to consume all her endowment in one period only.

• The individual has diminishing marginal rate of substitution. This implies that individuals
have to be compensated more to part with or are less willing to give up a consumption good
if they have little of them in the first place.

• The individual is able to rank consumption bundles over time in order of preference. Thus
given two bundle of goods, bundles A and B, the consumer can say whether she prefers bundle
A over bundle B or vice-versa or is indifferent between the two.

Hence these assumptions imply that the individual will have indifference curves that are convex to
the origin. A typical indifference curve is shown in Figure 1 where the amount of consumption of
good 1 is on the x-axis and the amount of consumption of good 2 is on the y-axis. It is clear that
there are diminishing marginal rate of substitution.
To illustrate this point, suppose we start at point A. Suppose we reduce the second period
consumption (c2 ) of the individual by 2 units. The indifference curve tells us that to keep the
individual’s utility constant, we have to compensate the individual by increasing the first period
consumption by the 2 units also. This moves the individual to point B. Now suppose we reduce
the second period consumption of the individual by another 2 units. It is clear that this time
the consumer has to be compensated by 6 more units of consumption in the first period (from 5
units to 11 units). Thus individuals are less willing to give up (or have to be compensated more)
consumption good if they have little of them in the first place.

5.2 Optimal consumption choice

Before we solve for the optimal choice of the consumer, we introduce some notation. We denote the
amount of the good that is consumed by an individual in her first period of life by c1,t . Similarly
c2,t+1 denotes the amount of goods the same individual consumes in the second period of her life.
Note that c2,t+1 represents consumption that occurs in t+1 period by individuals born at time t,
that is the consumption of the old generation born at time t. When the time period is not important
(as in steady-state or equilibrium), we will denote the first and second period consumption of an
individual as c1 and c2 respectively.
The problem facing the future generations of this economy is very simple. They want to
maximize their utility subject to their resource constraint and to maximize utility, they need to
consume a positive amount of goods in both periods. Therefore, they need to acquire goods in the
second period (remember they don’t have any endowment in the second period) and must find a
way to do so. Given that there is no storage technology, then the question is how can the future
generations acquire goods in the second period.
We will examine this problem from two perspectives. The first will be from a central planner’s
view where a benevolent social planner will maximize the utility of future generations on their

6
behalf. He will do so by allocating the economy’s resource between the young and the old. The
second solution, a decentralized or competitive solution will allow individuals to trade with each
other thereby acquiring goods when old. The existence of a medium of exchange, that is money
will permit trades to take place. We then compare the two solutions and examine which one offers
the consumer the highest utility. We begin with the central planner.

5.3 Optimal allocation under the central planner

Imagine for a moment that the central planner has complete knowledge of and total control of the
economy. The objective of the central planner is to allocate goods among the young and old such
that at each point in time, their utility is maximized.
Recall that Nt of young people are born or endowed with y. Thus the total amount of resources
in the economy (or consumption good) at any point in time is simply the number of young people
times their endowment.

Total amount of consumption good = Nt y (5)

Suppose that for the purpose of equity, each member of generation t is given the same amount of
consumption, that is the central planner treats the young persons as identical and the old persons
as identical. In this case, total consumption by the young generation in period t is:

Total young consumption = Nt c1,t (6)

and the total consumption by the old generation in period t is:

Total old consumption = Nt−1 c2,t (7)

To make the notation clear again, recall that the number of old people at time t are those who
were born at time t-1. There are Nt−1 of them and the consumption of each old person in period t
is given by c2,t . Therefore the total consumption of old people at time t is given by equation 7.
Total consumption at time t is thus the sum of the consumption of young and old at time t.
This is given by:
Total consumption = Nt c1,t + Nt−1 c2,t (8)
This represents the total demand for consumption at time t. Since in equilibrium demand must
equal to supply, therefore given that the supply of good at time t is simply equation 5, we have:

Nt c1,t + Nt−1 c2,t ≤ Nt y (9)

For simplicity, we assume that the population is constant (or alternatively there is one person of
each generation at each point in time), thus Nt = N , In this case, we can rewrite equation 9 as:

N c1,t + N c2,t ≤ N y (10)

Dividing by N on both sides, we have:

c1,t + c2,t ≤ y (11)

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We are concerned with stationary or equilibrium allocations. A stationary allocation is one that
gives members of the same generation the same consumption pattern over time. In other words,
under a stationary allocation, c1,t = c1 and c2,t = c2 for every period, t = 1, 2, 3, .... Note that
the stationary allocation does not imply that c1 = c2 . Thus with a stationary allocation, we can
rewrite equation 11 as:
c1 + c2 ≤ y (12)
The budget or resource constraint is shown in Figure 2. Note that any allocation on or below the
yy line is a feasible set of allocation. The point A is not feasible since it is unattainable given the
resources of the economy.

5.4 The golden rule allocation

The objective of the central planner is simple. She has to maximize the utility of future generations
on their behalf subject to a resource constraint. More formally, we have:
max u(c1 , c2 ) (13)
c1 ,c2
subject to c1 + c2 ≤ y (14)
Thus we can set up this problem using a simple Lagrangean and denoting λ as the Lagrange
multiplier.
ℓ = u(c1 , c2 ) + λ (c1 + c2 − y) (15)
The first order conditions for this simple maximization problem is:
∂ℓ
= u1 (c1 , c2 ) − λ = 0 (16)
∂c1
∂ℓ
= u2 (c1 , c2 ) − λ = 0 (17)
∂c2
∂ℓ
= c1 + c2 − y = 0 (18)
∂λ
The first condition implies that the marginal utility of consumption in period one, that is the
benefit of an additional unit of consumption good, u1 (c1 , c2 ), must equal the shadow price of that
consumption good , that is the cost of consuming that extra unit. We have the same expression for
consumption of the good in period 2. The third equation is simply the resource constraint. Total
demand c1 + c2 must equal to total supply. Note that if we substitute the first order condition for
c1 into the first order condition for c2 , we have:
u1 (c1 , c2 ) = u2 (c1 , c2 ) (19)
This implies that the marginal utilities of consumption must be equal across all the periods.
For example if u(c1 , c2 ) = ln c1 + β ln c2 . Thus using the first order conditions we have derived,
we have:
∂ℓ 1
= −λ = 0 (20)
∂c1 c1
∂ℓ β
= −λ = 0 (21)
∂c2 c2
∂ℓ
= c1 + c2 − y = 0 (22)
∂λ

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Using the first order conditions for c1 and c2 , we have:
1 β
= (23)
c1 c2
or
βc1 = c2 (24)
Using the above in the resource constraint, we have:
1 β
   
c∗1 = y, c∗2 = y (25)
1+β 1+β
Thus the social planner maximizes the utility of the future generations by allocating consumption
according to the optimal allocation we found above3 The point at which consumption is maximized

1
is known as the golden rule. In our example, the golden rule of allocation is thus c∗1 = 1+β y, c∗2 =
 
β
1+β y.
The golden rule allocation is shown in Figure 3. The golden rule is achieved at point A which
offers the individual the consumption bundle (c∗1 , c∗2 ). Note that this is achieved at the point of
tangency between the indifference curve and the resource constraint, that is where the slope of the
indifference curve is equal to the slope of the resource constraint.
This combination of (c∗1 , c∗2 ) yields the highest feasible set of utility given the resource constraint
and the preferences of the individual. For example points B and C are feasible but they are on a
lower indifference curve. Point D is preferable to point A, but it is unattainable given the existing
resource constraint.
Note that although the golden rule allocation maximizes the welfare of all individuals, it does
not maximize the welfare or utility of the initial old. To see this, recall that the initial old’s utility
depends solely and directly on the amount of the good they consume in their second period (and
last period) of their life. If the central planner’s goal were to maximize the utility of the initial old ,
she would give as much of the consumption as possible to the initial old. This would be represented
by point E in Figure 3. This would allocate y units (all of the units) of consumption goods to the
initial old and none to the young.
This stationary allocation where all the goods are allocated to the initial old and none to the
young would of course not maximize the utility of future generations since they prefer the more
balanced allocation bundle (c∗1 , c∗2 ). Faced with this conflict between the initial old and the future
generations, an economist cannot choose between them on objective ground. Nevertheless, on
subjective grounds, and influenced by the fact that there is one generation of initial old and an
infinite number of future generations, we tend to pay more attention to the golden rule allocation
and think that this allocation is more realistic and fair. Note that so far we have not said anything
about the existence or role of money.

6 Decentralized economy

In the previous section, we found that the feasible and optimal bundle of consumption goods that
a central planner would choose to allocate between the young and old generation. To achieve the
3
Try the same example with u(c1 , c2 ) = 1
c1−θ
1−θ 1
+ 1
c1−θ .
1−θ 2

9
 βy
optimal allocation, the central planner has to take away c∗2 = 1+β from each young person and
give this amount to each old person. Such a redistribution requires that the central planner have
the ability to reallocate endowments costlessly between the generations. Furthermore, in order to
determine c∗1 and c∗2 , the central planner must know the exact utility function of the individuals.
These are strong assumptions about the power and wisdom of the central planner. This leads
us to ask if there is some way where we can achieve this optimal allocation in a more decentralized
manner, that is one in which the economy reaches the optimal allocation through mutually beneficial
trades conducted by the individuals themselves. In other words, can we let the market do the work
instead of the central planner? That is can the market achieve a (competitive) equilibrium that is
as good as the central planner?
Before we answer this question, we first define what we mean by competitive equilibrium. A
competitive equilibrium has the following properties:

1. Each individual maximizes utility given her budget or resource constraint. In our economy,
they will do so by engaging in mutually beneficial trades with other individuals.

2. Each individual is a price taker and also a wage taker. This implies that the actions of a
single individual cannot influence prices and wages.

3. All markets clear. In our simple model, this implies that the supply of goods equals the
demand for goods and the supply of money equals the demand for money.

6.1 Equilibrium without money

Let us first consider the nature of a competitive equilibrium in an economy that do not use money
or where money does not exist. Recall that at time t, there are Nt young people who are born
with an endowment and Nt−1 old people who do not have any endowment. The utility of these
old can be increased if they can somehow give up some of their endowment when they are young
in exchange for some goods when they are old. Without the central planner, can we achieve this
result?
The answer to this question is clearly no in an economy without money. No such trades are
in fact possible without money. From Table 1, we can see that a young person in period t can
potentially trade with two types of persons: other young people of the same generation and old
people of the previous generation (people born in period t-1 ). It is clear that trade with fellow
young people would not be mutually beneficial since this would involve only swapping the same
good and they like him have none of the consumption good when old.
Trading with the old generation does not make sense also. The old generation would like to
have what the young generation have, that is a positive endowment, but they do not have what
the young would like since they will not be around the following period. For example, a young
knows that if she gives part of her endowment to the old person at time t, then she will never see
the endowment again since in period t+1, the old generation will disappear or die.
This lack of possible trade is the manner in which the OLG model captures the absence of
double coincidence of wants. In our example and model, each old generation wants what the young
generation has but does not have what the young generation wants.
The resulting equilibrium is autarkic, that is individuals have no economic interactions with
each other such that no trade occurs. Unable to make mutually beneficial trade and unable to carry

10
her endowment in the next period (the good is perishable and cannot be stored), each individual
therefore consumes her entire endowment when young and nothing when old.
As a result, in this autarkic equilibrium, utility is low. Both the future generations and the
initial generation is worse off in this case compared to the central planner’s case. It is clear that
each member of the future generation would be glad to give up some of their endowment when
young and consume when old while the initial old would like to consume a positive amount. In
other words, the existence of trade would make each generation better off. Hence, by introducing
a commodity, that is money, trade can take place and this would be Pareto improving.4

6.2 Equilibrium with money

To open up a trading opportunity that can allow individuals to move away from the autarkic
equilibrium, we now introduce fiat money in our simple economy. Fiat money is a worthless
commodity that is nearly costless to produce and that cannot itself be used in consumption or in
production. For the purpose of our example, we assume that a central bank can produce fiat money
costlessly and no one else can produce (or even counterfeit) it. Moreover, money can be costlessly
stored from one period to another and it is costless to exchange. Because individuals derive no
utility from holding money, money is valuable only if it enables individuals to trade for something
they want to consume.
A monetary equilibrium is a competitive equilibrium in which there is a valued supply of fiat
money. By valued, we mean that the fiat money can be traded for some of the consumption good.
For fiat money to have value, its supply must be limited (remember what happens to inflation and
hence the value of money when you have too much money in circulation) and it must be impossible
or very costly to counterfeit.
We begin our analysis of the monetary economy with an economy with a fixed stock of m
perfectly divisible units of fiat money. We assume that each of the initial old begins with an equal
number m N of these units. The presence of money opens up trading possibilities. A young person
can now sell part of her endowment of goods to an old person in exchange for money, hold that
money until the next period and then trade it for goods when they are old with a member of the
young generation. Thus the existence of money as a medium of exchange, by permitting trade, will
be Pareto improving. This is discussed in the next section.

6.3 The demand for fiat money

Trade will take place only if money is valued, in other words, if people are willing to give up some of
the consumption good in exchange for fiat money and vice versa. Because the value of fiat money
is intrinsically useless, its worth will depend on one’s view of its value in the future. If individuals
believe that money will be accepted for the exchange of goods in the future and its value will not
change, then they will be willing to hold money today. However, if it is believed that money will
have no value in the future, then individuals will simply choose not to hold money today. As a
result no trading will take place.
For an exchange to take place, people must believe that money will have a value in the future in
the sense that it can be exchanged for goods. Hence money will have no value today, if individuals
4
An allocation is Pareto improving if at the new allocation, everybody can be made better off without making
someone else worse off.

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know that at any future date T money will have no value. To see this consider, period T. If money
is worthless in period T, then individuals in period T-1 will not be willing to hold any fiat money.
Similarly, individuals in period T-2 will also not want to hold and demand money since they know
it is going to be worthless in period T-1. By similar reasoning, we can move back in time and show
that money will have no value today if it has no value at time T.
Assuming money is valued, we can now characterize the monetary equilibrium. Recall that in
her first period, the individual has an endowment y of goods. The individual can do two things:
she can consume them completely or sell them in exchange for money.
Denote the number of dollars acquired by an individual (by giving up some consumption goods)
at time t by mt . Denote the price of the consumption good at time t by pt . The price level denotes
how many units of fiat money an individual has to exchange for one unit of the consumption good.
Thus if more fiat money is needed in exchange of a unit of the consumption good, this implies that
the value of money has fallen. This implies that there is an inverse relationship between the price
level and the value of money.
Given the set of prices the budget constraint of an individual is given by:

pt c1,t + mt ≤ pt y (26)

The left hand side of equation 26 is simply the individual’s total uses of resources which consists
of the value of consumption pt c1,t and the acquisition of money, mt . The right hand side is simply
the total sources of resources or the value of the endowment the individual has and this is equal to
pt y. The above equation implies that the real demand for money by a young generation is simply:
mt
= (y − c1,t ) (27)
pt
You can view this as savings. That is one way an individual can transfer her endowment from the
first period to the second period and consume it in the second period (when old) is to save part it.
In our simple model, this is achieved via the use of money.
In the second period of her life, the individual does not receive any endowment. However, when
old the individual can now buy goods by using the money she acquired in the previous period or
when young (that is she uses her savings). In the second period of her life, the money acquired
when young will purchase pt+1 c2,t+1 worth of consumption goods. Hence her budget constraint is:

pt+1 c2,t+1 ≤ mt or mt ≥ pt+1 c2,t+1 (28)

Substituting equation 28 into equation 26 for mt , we have:

pt c1,t + pt+1 c2,t+1 ≤ pt y (29)

Dividing by pt on both sides, we have the budget constraint for a young

pt+1
 
c1,t + c2,t+1 ≤ y (30)
pt
We have thus everything set up to answer our question: has theh introduction
i of money made people
pt+1
better of? Before we do so, we need to find an expression for pt

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6.4 Optimal allocation under a stationary equilibrium and constant population

Since the total supply of fiat money must be equal the demand for fiat money, that is the money
market must clear, we have:
mt
mt = pt Nt (y − c1,t ) or = Nt (y − c1,t ) (31)
pt
where the left hand side, mt is simply the total nominal money supplied and the right hand side is
simply the total amount of money demanded (nominal). This consists of the total amount of money
demanded by a single young individual, that is pt (y − c1,t ) (see equation 26) times the number of
young individuals which is simply Nt .
If we rearrange equation 31, we have:
mt
pt = (32)
Nt (y − c1,t )
and writing this equation one period forward, we have:
mt+1
pt+1 = (33)
Nt+1 (y − c1,t+1 )
Thus if we divide equation 33 by equation 32, we have:
mt+1
pt+1 Nt+1 (y−c1,t+1 )
= mt (34)
pt Nt (y−c1,t )

If we assume that the population is constant, that is Nt = N for all t and c1,t = c1,t+1 = c1 , we
have:
pt+1 mt+1
= (35)
pt mt
The above equation implies that prices will grow at the same rate as money in equilibrium. In
other words, this implies that the quantity theory holds in the long-run and the classical dichotomy
applies to this model. Money is neutral in the long-run since it affects prices only and does not
affect any real variable.
Assuming that the money supply is constant, that is mt = mt+1 , this implies that the price level
is also constant and equal to one. With pt+1
pt = 1 with a constant money supply and a stationary
equilibrium, we can rewrite the individual budget constraint as (that is equation 30)
p
 
c1 + c2 ≤ y or c1 + c2 ≤ y (36)
p
The objective of the individual is thus simple. The individual will want to maximize her utility
u(c1 , c2 ) subject to the budget constraint given by 36. We can set up the individual’s problem as:

max u(c1 , c2 ) (37)

c1 ,c2
subject to c1 + c2 ≤ y (38)

This is exactly the same problem as in the social planner’s case. Hence the competitive monetary
equilibrium will be the same as the planner’s solution and the optimal allocation in this case also

13
is simply the golden rule. In terms of a diagram, the solution which was depicted in Figure 3 for
the planner’s solution applies to the monetary competitive solution also.
Thus if we have u(c1 , c2 ) = ln c1 + β ln c2 , we get exactly the same solution as in the planner’s
y βy
case. That is c∗1 = 1+β , c∗2 = 1+β . Real money demand in that case is simply:

mdt y βy
 
= [y − c∗1 ] = y − = (39)
pt 1+β 1+β
Recall that in the absence of money, the optimal allocation was autarkic, that is the young gen-
eration would consume their entire endowment when young and nothing when old. This allocation
was inferior compared to the social planner’s allocation, that is the golden rule allocation.
The introduction of money, however, opened the possibility of trade between generations. Young
generations are willing to give up part of their endowment and acquire money which they can use
to acquire goods when old. As shown, the existence of money and trade makes everybody better.
The optimal solution is no longer autarkic. In equilibrium trade occurs.
Moreover, the competitive monetary equilibrium is exactly the same as the social planner’s
solution, that is the golden rule allocation is achieved. It is clear that the introduction of money
has made everybody better off. Allocations that were not attainable before are now possible with
money. Put simply, the introduction of money is Pareto improving.5

7 Monetary standards

Given the inefficiency of the barter system, it is not surprising that most economies have adopted
some form of money. Where money exists, there are certain rules and regulations that govern its
circulation, that is a monetary standard. Broadly speaking, throughout history, there have been
two types of monetary standards:
• Commodity standard in which a commodity preferably valuable and in limited in supply acts
as a basis for a monetary system. For example gold during the Gold standard acted as the
basis for the monetary system. The value of money or currency depended on the price of
gold. In such a system, a country’s currency (minted coins and paper currency) was backed
by the amount of reserves of gold. Any individual could technically exchange or redeem its
unit of currency for a given piece of gold.

• Fiat money system (paper money standard or token coins) where the circulating medium
of exchange is made of material that has extremely low costs of production and therefore
having no commodity value whatsoever (or a very low one). The fiat money system, unlike
the monetary standard, carries no promise whatsoever of being backed by a commodity such
as gold or silver presently or in the future. Most monetary system (if not all) are fiat money
system nowadays.
In the future, we may see another type of monetary standard which is e-money. With technology,
society may become a cashless economy, that is where all payments are done electronically without
the exchange of fiat money as we know it today. E-money is already gaining importance around the
5
Try the case when the population is not constant, that is Nt+1 = nNt . Is the social planner solution the same as
the competitive non-monetary and monetary solution? Does money improves welfare again?.

14
world. One of the main issues regarding the advent of e-money is whether or not central banks will
lose their monopoly power over the issuance of money and hence their ability to conduct monetary
policy.
Since central banks are the sole issuers of money (base money), they can exert control over the
supply of money and hence implements monetary policy by controlling its supply (for the sake of
argument, we will assume for now that central banks conducts monetary policy by controlling the
money supply). As long as individuals demand fiat money (or settlement balances) that are under
the direct control of central banks, the latter will be able to conduct monetary policy as we know
it and influence interest rate.
However, the growing importance of e-money can fundamentally alter and undermine the very
foundations of monetary policy. For example, what would happen to monetary policy as we know
it, if there is a private issuer of money and if individuals demand the money issued by the private
issuer rather than settlement balances issued by the central bank. For example, instead of having
private banks that have deposits at central banks, we may have other private institutions that can
act as custodian of wealth that do not issue any money or credit and do not hold account at central
banks.
In this case, how would the central bank exert a control on something there is no demand
for? Many economists such as Charles Goodhart argue that this is unlikely to happen since money
offers anonymity in transactions, something that e-money does not. Moreover, he argues that people
because of this anonymity feature of money and the fact that banks play unique and important
roles in our modern society, it is unlikely that fiat money and banks will disappear in the future.
This debate remains open among central bankers.

8 Conclusions

We presented int his lecture the various functions of money. Money as a medium of exchange
facilitates transactions and reduces the cost of transactions. On the other hand, money as a a unit
of account simplifies the price system, again making transactions simpler. Finally, money is also a
store of value, enabling individuals to transfer wealth from one period to the other.

9 References

Champ, B. and S. Freeman. 2001. Modeling Monetary Economies, Second Edition, Cambridge
Press. [CF]

15
Figure 1: Diminishing Marginal Rate of Substitution

Figure 2: Feasible Allocations

16
Figure 3: Optimal Allocations

17