Why is There Money? – by Ross M. Starr

Brûlé liégeois de Jean de heinsberg By Wikicommons

Money, like fire, the wheel, and written language, is one of the fundamental discoveries of civilization, yet it has no immediate use, it is a fiduciary token. Ross Starr offers a unique answer to the question Why is there Money? Developing a monetary theory from the prevailing Arrow-Debreu model of general economic equilibrium.

Why is there Money? develops a theory of money and a monetary economy consistent with the prevailing advanced theory of the economy as a whole (which had been heretofore unable to include money). The essential step is to augment the prevailing model by introducing transaction costs and pairwise structure of exchange.

Money, like fire, the wheel, and written language, is one of the fundamental discoveries of civilization. Despite the evident superiority of monetary trade over barter, it is puzzling. Monetary trade involves one party to a transaction giving up something desirable (labor, his production, a previous acquisition) for something useless (a fiduciary token or a commonly traded commodity for which he has no immediate use) in the hope of advantageously retrading it.

Prof. Carl Menger stated this issue as a paradox:

It is obvious … that a commodity should be given up by its owner …for another more useful to him. But that every[one] … should be ready to exchange his goods for little metal disks apparently useless as such…or for documents representing [them]…is…mysterious… why…is…economic man …ready to accept a certain kind of commodity, even if he does not need it, … in exchange for all the goods he has brought to market[?]

In modern economic theory, the ideal conception of an economy is the Arrow-Debreu mathematical general equilibrium model (known as Walrasian after its pioneer Léon Walras). This model combines the choice behavior of consumers and workers, the employment and production decisions of firms, and price formation in competitive markets, all interacting with one another. It fully accounts for prices of many goods and services affecting supply and demand decisions and those decisions affecting prices. The Arrow-Debreu model has become the standard framework for most economic theory, including microeconomics, finance, international trade, and macroeconomics.

Unfortunately the Arrow-Debreu model has a distinct omission. Its co- author, Nobel Laureate Gerard Debreu, notes “[An] important and difficult question…[is] not answered by the approach taken here: the integration of money in the theory of value…” Monetary theorists have long recognized this defect.

Nobel Laureate James Tobin wrote:

”pure economic theory has never delivered the tools to build a [microeconomically based theory of money]…. The utility maximizing individual and the profit maximizing firm… buy and sell, borrow and lend, save and consume … in a frictionless world … [where] transactions … are costless. Money holdings have no place in that world … ”

Why is there Money? augments the Arrow-Debreu model along the lines Tobin recommends. The Arrow-Debreu model sets a very high standard of parsimonious structure: assume as little as possible; infer as results as much as possible. Two innovations to the Arrow-Debreu model are sufficient: (i) trans- actions are a costly (resource using) activity and (ii) transactions take place pairwise, with purchases paid for in each transaction by delivery of equal value to the seller.

The commodity pairwise structure of exchange is formalized as a trading post model. For any two distinct commodities there is a separate trading post for their pairwise exchange. Starting with N commodities there are 1 N (N − 1) 2 separate trading posts. When most trading posts are active in market equilibrium, the economy is operating by barter. But when, in equilibrium, most posts are inactive, and activity is concentrated on N-1 posts trading a single good against the remaining N-1 other goods, then the economy is monetary with the single actively traded good as commodity money.

The budget constraint applies to each pairwise transaction separately. Ex- change is a resource using activity. Transaction costs are evident to buyers and sellers from a spread between bid and ask (wholesale and retail) prices. The requirement that payment be made for acquisitions, at each of many separate transactions, implies a role for a carrier of value between trades. Scale economy in transaction costs leads to a unique common medium of exchange. Fiat money’s acceptability in payment of taxes (following Adam Smith and Georg Knapp) ensures its positive value. These elementary economic conditions permit the model to conclude, in market equilibrium, that:

• Trade is monetary. One side of almost all transactions is the economy’s common medium of exchange.

• Money is (virtually) unique. Non-financial transactions in most places most of the time use a single common medium of exchange.

• Even transactions suitable for barter resolution, where the two parties have reciprocal demands and supplies (e.g. auto workers acquiring cars), are transacted with money.

• Money is government-issued fiat money, trading at a positive value though it conveys directly no utility or production.

This expanded Arrow-Debreu model emphasizes transaction costs and the multiplicity of separate pairwise transactions each fulfilling a budget constraint. It allows the theory to conclude that payment takes monetary form, as a common medium of exchange. Money is not an assumption but a conclusion of the theory based on elementary assumptions. Why is there Money? fulfills Tobin and Debreu’s stated need for a microeconomic foundation of monetary theory.

Dr. Ross Starr, the author of Why is there Money? and of General Equilibrium Theory: An Introduction, is Professor of Economics at the University of California, San Diego, in La Jolla California. He lives there with his wife, Susan, and their pet blue-and-gold macaw. Summers are spent near Stanford University on the San Francisco Peninsula where their children and grand- children are living. Recent visiting appointments have been at the European University Institute in Florence, Italy, and at the Paris School of Economics.

Why Is There Money?Walrasian General Equilibrium Foundations of Monetary Theory

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