A frictionless economy with suboptimizing agents

Abstract

The existence of short-term monetary equilibrium in a frictionless economy with suboptimal agents is proved for any (reasonable) given interest rate. Money is distinguished from monetary assets. Separability ideas (as defined in decision theory) are applied. Two financial markets are in operation: for bank contracts (deposits and credits) and for shares.

Keywords:

• separability in decision theory
• bounded rationality
• money
• short-term equilibrium
• monetary frictions

AMS Subject Classifications::

• 91B06
• 91B52
• 54C05

Acknowledgements

Financial support by the Spanish Ministry of Education and Science (project SEJ 2007-67068) is gratefully acknowledged.

Notes

Notes

1. Mercado did not compose 4 in Latin, but in Spanish: ‘nunca los hombres distinguen moralmente en sus negocios el dinero del derecho de haberlo, si, como digo, está seguro y líquido’. The statement is in the context of a qualified disapproval of usury.

2. ‘It is the rule that the bank turns away a customer whom it considers deserving of credit only if it is compelled to do so’ 14, III.5]. Of course, in the real world the bank acts not only through the rate of interest, but also by setting solvency conditions (and this affects the amount of credit). We suppose that the agents are blessed with moderation and restrain themselves up to the point of incorporating the bank's personal solvency conditions into their preferences.

3. In general, we define monetary assets as those whose prices (in terms of money) are fixed by the central bank (or whatever monetary authority). Gold has been historically a typical monetary asset, and one unit of money has been set as a fixed quantity of gold. Then the demand for gold has a ‘monetary’ component (coined gold), a ‘pure asset’ component (gold bullion) and a ‘commodity’ component (for jewellery, etc). Assuming full convertibility (including free coinage) and certain hypotheses, a suitable equation relating the demand and the supply of gold could arguably determine the level of prices. If only convertibility into coined gold (and no free coinage) is considered, a similar equation for metallic money (coined gold) can be contemplated; Wicksell's quantity equation may be interpreted in this way.

4. In the real world, the budget of the public sector also provides an anchor.

5. A weakened version of (A.7) would be sufficient for our purposes, namely: if and , then ; if and , then .

6. ‘Arbitror autem regulariter esse in more positum, ut in fine nundinarum soluantur, praescriptumque esse certum tempus finitis, aut fere finitis nundinis, eiusmodi solutionibus, atque ante id tempus quam plurima chirographis peragi, eo quod non sit tanta copia pecuniae, ut tam ingens mercium multitudo, quae eo deferuntur, ac venduntur, pecunia statim numerata emi possit, atque ut tam multa negotia pecunia ultro citroque in eis expediantur.’ The English translation is in 9.

7. How this control is implemented, and with what success, is an institutional issue that has changed along history. About the present situation, we agree with 13: ‘In an open and efficient financial system, the central bank can determine the market rate of interest by standing in the market at its own rate, and rely on interest rate arbitrage to transmit that rate to the market’.