lOMoAR cPSD| 45211451
CHAP 3 Modeling Monetary Economies 4th Edition
MONEY AND BANKING
, lOMoAR cPSD| 45211451
Chapter 3
Barter and Commodity Money
1 Roadmap
In this chapter, we extend the basic overlapping generations
model so that we can examine other ways in which people
pay for things. We know that fiat money can be used to
execute trades between people from different generations.
So we consider what happens if there is trade amongst
people of the same generation. We introduce multiple types of
consumption goods so that there could be a reason for
people to trade. Within a generation, the friction here is
the cost associated with each meeting, known also as search
costs. For trade to occur, there must be a double coincidence of
wants; I have what you want and you have what I want. In
the first comparison, we examine whether money or barter
is the least costly way to execute trades. Even with
consumption goods being allowed to be storable, money can
reduce lifetime search costs compared with barter for economies
with lots of different goods. With money as the generally
accepted medium of exchange, every meeting between young
person with goods and an old person with money means that
in every meeting a young is offered something they
want. Hence, the search costs associated are reduced. In a
double-coincidence problem, the probability that you have what I
want and I have what you want is difficult when there are lots
of different consumption goods. However, when money is
involved, the doublecoincidence problem now requires that if
you want what I have and I have money, we will always
trade because you accept money.
Thenext comparison is between fiat money and commodity
money. Human history has predominantly relied on commodity
money – either actualprecious metals or paper money that
stands for a specified amount of precious metal – as
, lOMoAR cPSD| 45211451
a means of payment. It is easy to understand why we
would not want to use anything that has intrinsic value as a
means of payment. It is true that the monetary value
cannot be less than the intrinsic value of the commodity. But
it is generally better to free up the commodity and use
intrinsically useless fiat money to conduct trades. In this
way, everyone gets to enjoy the commodity’s intrinsic qualities by
substituting an intrinsically useless good as the means of exchange.
2 Barter and Commodity Money
Exchange solvesa mismatch problem for people. Often, a
person produces goods but wants to consume other goods. In
Chapter 2, we modeled this problem by assuming that
people had goods when young but also wanted to consume
when old. Because of the model’s simplicity, we use it as the
foundation on which we build more complicated models.
Thesimple model, however, provides no alternatives to fiat
money – fiat money is used in exchange because
there is no other way to trade what one has for what one wants.
The model has only a single type of good in every period,
so trading goods for goods is ruled out. In this chapter, we
consider models of two historically important alternative trading
possibilities – direct barter and commodity money. In a fiat
monetary system, goods trade for fiat money, but goods trade directly
for goods in an economy with barter or commodity money.
We distinguish between the two in the following way: In a
direct barter economy, the goods one owns are exchanged for the
goods one desires. In a commodity money economy, the goods one
owns may be traded for a good that is not consumed but
is traded, in turn, for the good one desires.
In each case, we compare the performance of the model
economy using fiat money with the alternative trading device. The
first model illustrates how direct barter may be more costly than
monetary exchange, the trading of goods for money and,
subsequently, money for goods. In the second model, real
CHAP 3 Modeling Monetary Economies 4th Edition
MONEY AND BANKING
, lOMoAR cPSD| 45211451
Chapter 3
Barter and Commodity Money
1 Roadmap
In this chapter, we extend the basic overlapping generations
model so that we can examine other ways in which people
pay for things. We know that fiat money can be used to
execute trades between people from different generations.
So we consider what happens if there is trade amongst
people of the same generation. We introduce multiple types of
consumption goods so that there could be a reason for
people to trade. Within a generation, the friction here is
the cost associated with each meeting, known also as search
costs. For trade to occur, there must be a double coincidence of
wants; I have what you want and you have what I want. In
the first comparison, we examine whether money or barter
is the least costly way to execute trades. Even with
consumption goods being allowed to be storable, money can
reduce lifetime search costs compared with barter for economies
with lots of different goods. With money as the generally
accepted medium of exchange, every meeting between young
person with goods and an old person with money means that
in every meeting a young is offered something they
want. Hence, the search costs associated are reduced. In a
double-coincidence problem, the probability that you have what I
want and I have what you want is difficult when there are lots
of different consumption goods. However, when money is
involved, the doublecoincidence problem now requires that if
you want what I have and I have money, we will always
trade because you accept money.
Thenext comparison is between fiat money and commodity
money. Human history has predominantly relied on commodity
money – either actualprecious metals or paper money that
stands for a specified amount of precious metal – as
, lOMoAR cPSD| 45211451
a means of payment. It is easy to understand why we
would not want to use anything that has intrinsic value as a
means of payment. It is true that the monetary value
cannot be less than the intrinsic value of the commodity. But
it is generally better to free up the commodity and use
intrinsically useless fiat money to conduct trades. In this
way, everyone gets to enjoy the commodity’s intrinsic qualities by
substituting an intrinsically useless good as the means of exchange.
2 Barter and Commodity Money
Exchange solvesa mismatch problem for people. Often, a
person produces goods but wants to consume other goods. In
Chapter 2, we modeled this problem by assuming that
people had goods when young but also wanted to consume
when old. Because of the model’s simplicity, we use it as the
foundation on which we build more complicated models.
Thesimple model, however, provides no alternatives to fiat
money – fiat money is used in exchange because
there is no other way to trade what one has for what one wants.
The model has only a single type of good in every period,
so trading goods for goods is ruled out. In this chapter, we
consider models of two historically important alternative trading
possibilities – direct barter and commodity money. In a fiat
monetary system, goods trade for fiat money, but goods trade directly
for goods in an economy with barter or commodity money.
We distinguish between the two in the following way: In a
direct barter economy, the goods one owns are exchanged for the
goods one desires. In a commodity money economy, the goods one
owns may be traded for a good that is not consumed but
is traded, in turn, for the good one desires.
In each case, we compare the performance of the model
economy using fiat money with the alternative trading device. The
first model illustrates how direct barter may be more costly than
monetary exchange, the trading of goods for money and,
subsequently, money for goods. In the second model, real
