Foundations of Monetary Theory: Money as a Medium of Exchange

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Recent work on the foundations of monetary economics has emphasized the conceptual weakness of traditional treatments of money in macroeconomic theory, but has not done much to correct those weaknesses. Until they are corrected, the important critical contribution of the rational expectations revolution will not have provided us with a satisfactory alternative with which to address major issues concerning monetary policy. The goal of the proposed research is to develop some new theories of monetary economics, by taking seriously the notion that money is an object that helps to overcome frictions in the exchange process; that is, money is a medium of exchange. Although the medium of exchange role of money was emphasized by the classical economists, formal modelling of this function has been elusive. The dominant paradigms in monetary economics today,, including overlapping generations models and cash-in-advance models, do not capture this function of money very well. While they have clearly proven to be very useful in addressing many substantive issues in money and macroeconomics, it is fair to say that these paradigms fail to provide an endogenous explanation of how objects come to be used as media of exchange, and therefore they are not able to address many fundamental issues of monetary theory and policy. This project will develop a framework related to equilibrium search and matching models. It will be used to explain the role of money endogenously and explore theoretical and policy implications.