Money and Capital as Competing Media of Exchange in a News Economy

By David Andolfatto and Fernando Martin

http://d.repec.org/n?u=RePEc:sfu:sfudps:dp09-02&r=dge

Conventional theory suggests that fiat money will have value in capital poor economies. We demonstrate that fiat money may also have value in capital-rich economies, if the price of capital is excessively volatile. Excess asset-price volatility is generated by news; information that has no social value, but is privately useful in forming forecasts over the short-run return to capital. One advantage of fiat money is that its expected return is not linked directly to news concerning the prospects of an underlying asset. When money and capital compete as media of exchange, excess volatility in the short-term returns of liquid asset portfolios is mitigated and welfare is improved. A legal restriction that prohibits the use of capital as a payment instrument renders the expected return to money perfectly stable and, as a consequence, may generate an additional welfare benefit.

Fiat money is a strange object, and its value sometimes is sometimes determined in a counter-intuitive fashion. In this case, money should have little value if there is ample capital available as a store of value and medium of exchange. However, value uncertainty of capital may overcome its dominance over money. That makes sense, and is expressed nowadays by a large increase in money demand. The surprising bit is that forcing people not to use capital for payment is welfare improving.

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