Chapter 15 TopicsAlternative forms of money.Money and the absence of double coincidence of wants.The causes and effects of long-run inflation.Financial intermediation and banking.

Alternative Forms of MoneyCommodity moneyCirculating private bank notesCommodity-backed paper currencyFiat moneyTransactions deposits at banks

The Double-Coincidence Problem and the Role of MoneyBarter exchange is difficult in highly-developed, specialized economies.Economic exchange requires search costs, and these costs are high when economic agents are specialized in consumption and production, and can only trade a good or service for another good or service.Search costs are reduced dramatically if everyone accepts money in exchange for goods and services.

Figure 15.1 An Absence-of-Double-Coincidence Economy

Figure 15.2 Good 1 as a Commodity Money in the Absence-of-Double-Coincidence Economy

Figure 15.3 Fiat Money in the Absence-of-Double-Coincidence Economy

The Effects of Long-Run InflationUse the monetary intertemporal model from Chapter 10.Show that money is not superneutral higher money growth causes higher inflation, which affects real economic variables.An increase in the money growth rate increases the inflation rate and the nominal interest rate, and reduces employment and output.

Figure 15.4 Scatterplot of the Inflation Rate vs. the Growth Rate in M0 for the United States, 19602006

Equation 15.1Assume that the central bank causes the money supply to grow at a constant rate.

Equation 15.2In equilibrium, money supply equals money demand.

Equation 15.3Money supply also equals money demand in the future period.

Equation 15.4Combine the previous two equations.

Equation 15.5The consumers intertemporal marginal condition.

Equation 15.6Marginal condition reflecting the consumers tradeoff between current leisure and future consumption:

Equation 15.7Marginal condition reflecting the consumers tradeoff between current leisure and current consumption:

Figure 15.5 The Long-Run Effects of an Increase in the Money Growth Rate

The Friedman RuleInflation causes an inefficiency, in that it distorts intertemporal decisions.The Friedman rule is a prescription for monetary growth that eliminates the inefficiency caused by inflation.The Friedman rule specifies that the money stock grow at a rate that makes the nominal interest rate zero.In practice, no central bank appears to have adopted a Friedman rule to guide monetary policy.

Equation 15.9Pareto optimality requires that

Equation 15.10In a competitive equilibrium,

Equation 15.11Also, in a competitive equilibrium,

Properties of AssetsRate of returnRiskMaturityLiquidity

Defining Characteristics of Financial IntermediariesBorrow from one group of economic agents and lend to another.Well-diversified with respect to both assets and liabilities.Transform assets.Process information.

The Diamond-Dybvig Banking ModelThree periods, 0, 1, and 2.Two types of consumers: early (consume in period 1) and late (consume in period 2)Efficient economic arrangement is for consumers to set up a bank in order to share risk.Given the banks deposit contract, the bank is open to a run, which is a bad equilibrium.

Figure 15.6 The Utility Function For a Consumer in the DiamondDybvig Model

Figure 15.7 The Preferences of a DiamondDybvig Consumer

Equation 15.12The marginal rate of substitution of early consumption for late consumption is

Equation 15.13First constraint that a deposit contract must satisfy is

Equation 15.14Second constraint that a deposit contract must satisfy is

Equation 15.15Combine the two constraints to get one:

Equation 15.16Re-write the constraint:

Figure 15.8 The Equilibrium Deposit Contract Offered by the DiamondDybvig Bank