The Purchasing Power of Money in an Exchange Economy

Abstract

It is shown that completely unbacked fiat money, issued by generic supplier implementing realistically specified monetary policy designed to obey certain sufficient conditions, is endogenously accepted by rational individuals at uniquely determined price level. The model generalizes the asset-pricing framework of Lucas (1978) to an economy with frictions, and specialization in production, without imposing the cash-in-advance constraint. The uniqueness of equilibrium comes from complete characterization of both the environment, and the equilibrium concept. In particular, rational consumers are allowed to perceive and exploit arbitrage opportunities associated with the existence of money as easily traded object. The results challenge the view that the value of money is inherently unstable absent active policy intervention, or that money can become worthless due to self-fulfilling expectations. Monetary policy canonically features two dimensions, one of which corresponds to nominal interest rate, and the other to continuous helicopter drop of net worth, which can be implemented as universal basic income.