On Money as a Medium of Exchange

This 1989 Journal of Political Economy paper by Nobuhiro Kiyotaki and Randall Wright builds a general-equilibrium random-matching model in which the identity of “money” is determined endogenously, rather than assumed, by solving for which commodities agents actually choose to accept in trade. Three types of infinitely-lived agents, each specialized in producing one good and consuming another, meet in random bilateral pairs each period and can only trade quid pro quo (no credit); the paper exhaustively characterizes every steady-state pure-strategy Nash equilibrium of this economy under two different consumption-production patterns, finding that, depending on relative storage costs, either a single low-storage-cost good becomes the unique commodity money or two different goods simultaneously circulate as media of exchange, with some multiple-equilibrium cases in which the outcome depends on extrinsic belief alone rather than on storage costs. The paper also constructs steady-state equilibria in which an intrinsically useless object (“fiat money”) circulates as the economy’s general medium of exchange provided everyone believes others will accept it, a self-fulfilling-prophecy property the authors call “tenuous,” and such fiat-money equilibria can coexist with leftover commodity money. On welfare, the decentralized trading equilibria are not generally Pareto optimal, multiple equilibria generally cannot be Pareto-ranked against one another, and introducing fiat currency into a commodity-money economy can (for some, not all, parameter values) raise welfare unambiguously, although too much fiat money in circulation is always welfare-reducing. Finally, standard “moneyness” indicators are shown to behave in counterintuitive ways: velocity of circulation turns out to be a poor indicator of which goods are actually serving as money, while acceptability and a liquidity measure (expected time to reach one’s consumption good) track the medium-of-exchange role much better.

Nobuhiro Kiyotaki | Macro Paper Warehouse

On Money as a Medium of Exchange