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Money and capital as competing media of exchange in a news economy

  • David Andolfatto
  • Fernando M. Martin

Conventional theory suggests that fiat money will have value in capital-poor economies. We demonstrate that fiat money may also have value in capital-rich economies, if the price of capital is excessively volatile. Excess asset-price volatility is generated by news; information that has no social value, but is privately useful in forming forecasts over the short-run return to capital. One advantage of fiat money is that its expected return is not linked directly to news concerning the prospects of an underlying asset. When money and capital compete as media of exchange, excess volatility in the short-term returns of liquid asset portfolios is mitigated and welfare is improved. A legal restriction that prohibits the use of capital as a payment instrument renders the expected return to money perfectly stable and, as a consequence, may generate an additional welfare benefit.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2009-046.

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Date of creation: 2009
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Handle: RePEc:fip:fedlwp:2009-046
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