Why is there Money?

Why is there Money?

Walrasian General Equilibrium Foundations of Monetary Theory

Ross M. Starr

The microeconomic foundation of the theory of money has long represented a puzzle to economic theory. Why is there Money? derives the foundations of monetary theory from advanced price theory in a mathematically precise family of trading post models.

Chapter 6: Uniqueness of Money: Scale Economy and Network Externality

Ross M. Starr

Subjects: economics and finance, history of economic thought, money and banking


1 Uniqueness of the medium of exchange and the use of monetary trade even in the presence of double coincidence of wants is explained by scale economies in transaction costs. A network externality encourages all transactions to proceed through the single common medium of exchange. 1 UNIQUENESS OF THE MEDIUM OF EXCHANGE: SCALE ECONOMIES IN TRANSACTION COST Monetary trade is typically characterized by a unique medium of exchange or a small number of related media (for example, currency, credit cards, travelers’ checks, all denominated in US$). How does this come about? Tobin (1980, p. 86) suggests that scale economies and a network externality in transaction costs are essential: The use of a particular language or a particular money by one individual increases its value to other actual or potential users. Increasing returns to scale . . . explains the tendency for one basic language or money to monopolize the field. When monetization takes place, households supplying good i and demanding good j are induced to trade in a monetary fashion, first trading i for ‘money’ and then ‘money’ for j, by discovering that transaction costs are lower in this indirect trade than in direct trade of i for j. But as Example 5.2 points out, monetization of trade is no guarantee of uniqueness of the medium of exchange. Scale economies in transaction costs induce specialization in the medium of exchange function. High volume leads to low unit transaction costs (see also Howitt and Clower, 2000, Rey, 2001 and Starr and Stinchcombe, 1999). Scale...

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