Existence and uniqueness of ‘money’ in general equilibrium: natural monopoly in the most liquid asset

Summary

The monetary character of trade, use of a common medium of exchange, is shown to be an outcome of economic general equilibrium in the presence of transaction costs and market segmentation (in trading posts with a separate budget constraint at each transaction). Commodity money arises endogenously as the most liquid (lowest transaction cost) asset. Scale economies in transaction cost account for uniqueness of the (fiat or commodity) money in equilibrium, creating a natural monopoly. Trading posts using a medium of exchange create a network externality inducing others’ adoption of the same medium. Bertrand monetary equilibria (among competing trading posts) and uniqueness of ‘money’ are robust to threats of entry. Government-issued fiat money has a positive equilibrium value from its acceptability for tax payments and sustains its natural monopoly through the scale of government economic activity.

This paper has benefited from seminars and colleagues’ helpful remarks at the University of California — Santa Barbara, University of California-San Diego, NSF-NBER Conference on General Equilibrium Theory at Purdue University, Society for the Advancement of Behavioral Economics at San Diego State University, Econometric Society at the University of Wisconsin Madison, SITE at Stanford University-2001, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Minneapolis, Midwest Economic Theory Conference at the University of Illinois Urbana Champaign, University of Iowa, Southern California Economic Theory Conference at UC — Santa Barbara, Midwest Macroeconomics Conference at University of Iowa, University of California Berkeley, European Workshop on General Equilibrium Theory at University of Paris I, Society for Economic Dynamics at San Jose Costa Rica, World Congress of the Econometric Society at University of Washington, Cowles Foundation at Yale University. It is a pleasure to acknowledge comments of Henning Bohn, Harold Cole, James Hamilton, Walter P. Heller, Mukul Majumdar, Harry Markowitz, Herbert Newhouse, Joseph Ostroy, Chris Phelan, Meenakshi Rajeev, Wendy Shaffer, Bruce Smith, and Max Stinchcombe.