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We continue on the theme of government and money in this chapter. Instead of having only one government at a time, however, we move on to consider a world in which each government has its own monetary policy. Indeed, the main piece added in this chapter is to examine the question: What happens when each country issues its own fiat money? The organizing principle is that there is a price at which each currency trades for another country’s currency.
It is time to let people trade. Given the people who live in this economy, it is straightforward to expect that young people have something – the consumption with which they are endowed – that old people want. For the trade to be mutually beneficial, the old people must have accumulated something valuable when young that serves as a kind of “store of value.” By offering this to the young person, we may get a trade.
In this chapter, our goal is to develop a model of the economy and then show how a make-believe, benevolent planner would choose the allocation. In other words, the planner would maximize the lifetime utility of all people living two periods subject to the resource constraint.
So far, people in our model economy have had only one way to acquire consumption at a later time – by holding fiat money. In the real world, however, there are many other assets. In this chapter, we concentrate on one particular alternative asset, capital. Capital is different from fiat money in that when people acquire capital this period, the capital produces goods next period and thus affects an economy’s output.
In Chapter 14, we examined a model economy in which bank insolvency can arise. But there is nothing in the model that looks like money in the sense that there are no explicit trades. What banks hold are real assets as a young person deposits goods to withdraw at a future date. A bank chooses from either a storage good or capital. Yes, storage is more liquid than capital in the sense that it matures in one period instead of two periods, but there is no reason for intergenerational trade between people in Chapter 14.
Perhaps you are seeing a recurring message appearing in Part II of this book. Specifically, when productive capital (i.e, when 𝑥 > 𝑛) is available as a competing store of value, fiat money can be inefficient in two possible ways. First, fiat money offers a lower return, which discourages people from holding and using this liquid form of money.
In this final chapter, we look into what it means for a central bank to be independent. We demonstrated that people holding nominal debt suffer a real loss in value when there is an unexpected inflation rate increase. So if the central bank operates in cahoots with the treasury, we can imagine a government tempted to rid itself of a burdensome national debt by inflating it away. Countries have taken some effort to make the central bank independent of the treasury. But there is no commitment that is so binding that a potential bond holder ever completely trusts the government not to inflate.
From Chapter 9, we have explained how banks can improve welfare by transforming illiquid capital into liquid deposits. An important by-product of this explanation is that there are two types of money: fiat money and deposits. One distinctive characteristic is that fiat, or outside, money is a liability of the monetary authority and a bank deposit, or inside money, is a liability of a commercial bank.
Thus far, the banks we have studied have been very simple. A bank accepts deposits and makes loans. The bank does not face any risk and is always solvent. Yet banks are subject to risk as asset values change over time. One particular risk associated with a bank is that its primary job is to transform liquid deposits into illiquid assets. This transformation alone subjects the bank to risks.
In this chapter, there are two new things to include in our analysis. First, we analyze random, unforecastable changes in monetary policy. In Chapter 5, we studied how permanent, anticipated changes to the fiat money stock growth rate would affect the return and welfare. Now we can talk about monetary surprises and their effects.
So far, we have shown that money is memory, it reduces transaction costs compared with barter, and it frees up resources compared with a commodity money economy. In Chapter 3, we focused on the demand for money. All good things. The next step is to consider how changes in money supply affect economic decisions.
In Chapter 8, we started with new stores of value that were perfect substitutes for fiat money. In these economies, we learned that if the return on other assets is greater than that of fiat money, fiat money will not be valued. Yet, when you look around, you see that fiat money is valued in many real economies even though other assets, like capital, have a greater return than fiat money.