Part 1.

The environment
Building a Model of Money
Why do we need a special theory of
money?
How is money different than bananas?
Money is not intrinsically useful.
Agents acquire goods because they
want to consume them.
But, money is acquired to facilitate the
acquisition of goods in the future.
Money Medium of Exchange
Building a Model of Money
What are the essential characteristics for a
monetary economy?
A Model with money requires:
1. Some friction to trade:
If agents can trade goods for any other good
at no cost, there is no role for money (trade
can occur as social memory imposes
discipline).
2. Someone must be willing to hold money from
one period to the next.
How to Create a Model of Money
There are two possibilities to meet the
second requirement:
Agents live forever
Individuals die but their generations
overlap
For many applications, life span does
not matter.
The Model Economy
Same physical environment as in
Chapter 1
Each period young people are born.
Each person lives for two periods,
except initial old.
There is a single perishable good which
young person receives.
Everyone wants to consume when
young and when old.
Part 2. The Economic Problem
The Economic Problem
Two solutions:
Centralized solution: benevolent planner
Decentralized solution: trades with money
Feasible Allocations: Golden Rule

c2
A: Golden Rule Allocation
y
B D

c2* A

U2

C U1
U0
c1
c1* y
Part 3. Decentralized Solutions
Decentralized Solutions
Disadvantage of the centralized
solution:
Strong assumptions about the power and
wisdom of central planner.
Achieving the golden rule allocation
requires redistribution from young to old.
Can markets solve the allocation
problem?
Equilibrium without Money
Is trade possible without money?
No, because
Each generation wants what the next
generation has
but does not have what the next generation
wants.
Absence of double coincidence of wants

Result: Autarky (no trade)

Equilibrium with Money
To open up a trading opportunity we
introduce Fiat Money:
It is intrinsically useless: no agent derives
utility from consuming it.
It can be stored costlessly.
Provided by the government at no cost.
Fully divisible.
Cannot be counterfeited.
Monetary Competitive Equilibrium (i)
A Monetary Equilibrium is a
competitive equilibrium in which fiat
money is valued.
Despite being intrinsically useless, fiat
money can be traded for some of the
consumption good.
Monetary Competitive Equilibrium (ii)
There is a fixed stock of M perfectly
divisible units of fiat money
Each of the initial old begins with an
equal number, M/N, of these units.
Now, a young person can sell some of
her endowment of goods for fiat money
(to the old).
Part 4. Finding the Demand for
Fiat Money
Demand for Fiat Money
The value of 1 unit of fiat money in
terms of goods: t
It is the number of goods that one must
give up to obtain one dollar.
It is the inverse of the dollar price of the
consumption good.
The dollar price of the consumption
good is pt.
An Individuals Budget (i)
The budget constraint facing the
individual in the first period of life is:

c1,t + t mt y
Consumption c1,t plus the goods sold
t mt cannot exceed endowment y.
An Individuals Budget (ii)
Budget constraint for the second period
of life:

c2,t+1 t+1 mt

Consumption in the second period of life c2,t+1

cannot exceed real money holdings t+1 mt .
An Individuals Budget (iii)
Putting the cash constraints for both
periods together yields:

c1,t + (t /t+1) c2,t+1 y

An Individuals Budget (iv)
Lifetime budget constraint:
c1,t + (t /t+1) c2,t+1 y

t+1 / t is the (real) gross rate of return

of fiat money

Net rate of return is t+1 / t - 1

Agents consumption choice
c2

t 1
y
t

c2*,t 1 A

c1*,t y c1
Fiat Moneys Rate of Return
Value of fiat money depends on an
infinite chain of expectations about its
future value.
If views about the future are the same
across generations, then individuals will
react in the same manner always.
They will always choose c1,t = c1 and
c2,t = c2
Stationary Equilibrium
Expectations
Individuals form their expectations of
the future rationally:
Rational Expectations
Individuals have Perfect Foresight:
Individuals expectations of future
variables equal the actual values of
these variables, no forecast errors.
An individual born in period t will
perfectly forecast the value of money in
period t+1.
 Demand for fiat money is the number of
goods each agent chooses to sell for
fiat money, i.e. the goods it does not
consume when young, y - c1,t.

Aggregate demand for money is

Nt (y - c1,t).
Money market
Equality of money demand and supply
requires:

t Mt = Nt (y - c1,t)

Solving for yields

t = Nt (y - c1,t) / Mt
and

t+1 = Nt+1 (y - c1,t+1) / Mt+1

 Rate of return of money
Solving for the real rate of return of fiat
money then yields:
N t 1 y c1,t 1
t 1 M t 1

t N t y c1,t
Mt

and
N t 1y c1 N t 1
t 1 M t 1 M t 1

t 1
t N y c Nt
Mt Mt
 We assume
Constant population Nt+1 = Nt
Constant supply of money Mt+1 = Mt

Cancelling the terms yields

t 1
1 t 1 t
t
The Role of Fiat Money
The introduction of fiat money improves
welfare.
Without fiat money there is no trade
between generations.
With fiat money trade between
generations takes place.
Part 5. Is the Monetary Equilibrium
the Golden Rule?
This Equilibrium = Golden Rule?
We have seen that fiat money improves
the welfare of individuals.
Centralized solution led to golden rule
allocation.
Does a monetary equilibrium also result
in the best possible allocation of goods?
Does the stationary monetary
equilibrium maximize the welfare of
future generations?
This Equilibrium = Golden Rule?
Compare the budget line with the
feasible set line: they are identical.
Hence, consumption will be identical.
Thus, the decentralized economy with
money leads to the golden rule
allocation.
This will not always be the case: budget
set and feasible set answer different
economic questions.
This Equilibrium = Golden Rule?
The use of fiat money

Maximizes welfare of future generations

The initial old are also better off. They

receive 1 M / N units of the consumption
good when they trade their initial holdings
of money for goods.
This Equilibrium = Golden Rule?
A stationary consumption bundle of a
monetary equilibrium satisfies two basic
properties:
It provides the maximum level of utility
given the individuals budget set.
It lies on the feasible line, with the
boundary of the set representing all
feasible per capita allocations.
This Equilibrium = Golden Rule?

c2
A: Golden Rule Allocation
y

c2* A

c1* y c1