Friday, April 22, 2011

The key to understand money: vacations

Monetary theorists have struggled for decades if not centuries to explain why we use and value money. Modern theory, which needs to be more explicit about its assumptions, has highlighted how silly some axioms of monetary theory are. For example, why would money make any sense in a utility function when future consumption is already taken into account? Or what about cash-in-advance in quarterly models of the business cycle. Money search model bring progress to the table as they model the problem of the absence of double coincidence of wants, although still with some rather crude assumptions. But at least it is going in the right direction.

Andrew Clausen and Carlo Strub come up with a new motivation for money. Suppose that there is a fix cost in production. Unless you want to produce at full capacity every period, you will then choose to close all operations from time to time and take a vacation. But you must live from something when you do not work and you have no savings technology. This is where money comes to the rescue. Without it, it would have been impossible to smooth consumption across periods, and thus money is valued and welfare enhancing. But beyond the possible elegance of the model, is anybody actually believing this story? I do not think in makes sense to discuss the intertemporal allocation of resources in a world without assets, especially if you want to apply it to anything modern.

4 comments:

Kansan said...

Is money used by people not taking vacations? Was money used before vacations were instituted? Case closed.

Andrew Clausen said...

We didn't want to claim that vacations are the primary reason money exists. The point of our paper is that predictable fixed costs create a problem that money can solve (with appropriate monetary policy). The traditional "search"-based idea of money is that agents need a liquid asset on hand to pay when an *unexpected* trading opportunity arises. We show that the unpredictability of trade is not the only reason to carry a liquid asset. Fixed costs are everywhere, and money can be used to smooth them out.

Of course, we could have had a more complicated and realistic model. For example, we seriously considered adding capital that has a fixed cost of liquidation. But, we felt that these complications would only distract from the main points of the paper, so we are saving this for future work. A paper should be as simple as possible to make its main points. We wonder what you would write about Townsend's classic turnpike model: "The key to understanding money: highways". Or Diamond's coconuts model, or Lucas' islands model, or ...

Anonymous said...

Simple OLG model of money already illustrates that money has value when it fascilitates saving, i.e. when young generation accept money from the old generation to save and smooth consumption. So the essence of this argument is already present in OLG model.

Andrew Clausen and Carlo Strub said...

We agree that OLG models give a lot of interesting insights and it is true that the front-loading of consumption to avoid the inflation tax may be illustrated in OLG models. However, we think our paper adds quite a few new ideas. Trading patterns and the distribution of money holdings are endogenous, and are affected by monetary policy. In the extreme case of the Friedman rule, the trading patterns can be very complicated (for example, tracing out the digits of pi!) Inflation "simplifies" these trading patterns, and inhibits smoothing out of non-convexities. At the Friedman rule, we show that non-convexities may be perfectly smoothed out over-time (as an alternative to lotteries, which also perfectly smooth non-convexities).