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The Search-Theoretic Approach To Monetary Economics - Rupert, Schindler, Shevchenko & Wright
The Search-Theoretic Approach To Monetary Economics - Rupert, Schindler, Shevchenko & Wright
The Search-Theoretic Approach To Monetary Economics - Rupert, Schindler, Shevchenko & Wright
Approach to
Monetary Economics:
A Primer
by Peter Rupert, Martin Schindler,
Andrei Shevchenko, and Randall Wright
Peter Rupert is a senior
economic advisor at the
Federal Reserve Bank of
Cleveland; Martin Schindler is
a doctoral candidate in
economics at the University of
Pennsylvania; Andrei
Shevchenko is an assistant
professor of economics at
Michigan State University;
Randall Wright is a professor
of economics at the University
of Pennsylvania. This paper
was written while Schindler,
Shevchenko, and Wright were
visiting the Federal Reserve
Bank of Cleveland.
These must satisfy the equilibrium conditions given
y. The first assumption, prob iWi
0, means that no below. We will say that money is used as a medium of
agent ever wants to consume his own output (which is exchange, or circulates, if and only if π π0 π1 0.
why they trade). The second assumption parameter- Let V0 and V1 be the value functions (lifetime, dis-
izes the extent of the basic search friction: The smaller counted, expected utility) of agents with 0 or 1 units
x is, the lower the probability that a random trader has of money. Since we consider only stationary and sym-
what you want. However, the third assumption is the metric equilibria, V j does not depend on time or on the
important one, since it parameterizes Jevons’ (1875) agent’s name, only his money inventories.
famous double coincidence of wants problem: The If we think of time as proceeding in discrete peri-
smaller y is, the lower the probability that a trader who ods of length τ , we can calculate the payoff of holding
has what you want also wants what you have.1 money as follows: The probability of meeting anyone
Besides the consumption goods already mentioned, during this period is approximately ατ by the Pois-
there is another object called money, which consists of
an exogenously fixed quantity of M 0 1 indivisible
son assumption.3 If the person you meet can produce The equilibrium conditions for π0 and π1 are
(meaning, in the version of the model that we are con-
0
duce, which occurs with probability x, and you both 0 0
want to trade, which occurs with probability π in equi- Notice that ∆ j depends on π , so to see if some candi-
librium, then you trade, consume, and continue with- date π0 and π1 constitute an equilibrium, one simply
out money, for a total payoff of u V0 . In all other inserts the π j and checks equation (5).
events (you meet no one, you meet someone with a Consider first the case γ 0 (fiat money). This im-
good you do not want, etc.), you simply continue with plies ∆1 0 for all parameter values, so we always
your money, for a payoff of V1 . In all events, you also have π1 1. Also, ∆0 is equal in sign to π0 π̂ , where
π̂
1
(6)
ατ 1 M xπ u 1 M u c
V1 V0
rτ
1
0 as
money. However, if
τ
0. Rearranging, we have
1
M 1 yu
c
rτ V1 ατ 1 M xπ u V0 V1 γτ oτ
r 1 M 1 y
Dividing by τ and taking the limit as τ 0, we ar- then π̂ 1, which means π0 1 is an equilibrium as
rive at the continuous-time Bellman’s equation, well. So there is also an equilibrium where fiat money
circulates as long as c is not too big.4 Finally, if π̂ 1,
(1) rV1 αx 1 M π u V0 V1 γ there is also a mixed-strategy equilibrium in which
An analogous argument implies that the value function exactly the right probability π̂ , you are indifferent as
for an agent without money satisfies to accepting or rejecting it, so randomizing is an equi-
librium.
(2) rV0 α xy 1 M u c α xM π V1 V0 c
to reduce notation (which we can always do with no The results for the general case are summarized as
loss of generality by redefining units of time appropri- follows:
ately), we have:
Mπ M y u c ru γ
∆1
r π
0 as
1 M π y u c rc γ τ
0.
∆0
(4)
r π
Proposition 1. There are five types of equilibria, and present an alternative model, first discussed by Siandra
they exist in the following regions of parameter space: (1993, 1996), where agents with money can produce,
and we simply impose the condition that agents can
1. π0 1 and π1 0 is an equilibrium iff r r2
r r4
agent with money is chosen and with probability 1 β
1
M yu c
1
M yu c
1
M 1 y u
r4
proposes cash).
c
These are the only (steady-state) equilibria. Proposition 2. In a double-coincidence meeting be-
tween an agent with and an agent without money,
Proof: See the appendix. generically the unique subgame-perfect equilibrium in
We characterized the regions where the different pure strategies is ψ0 ψ1 1.
equilibria exist in terms of r, but we could have used
some other parameter, such as c. Routine algebra im- Proof: See the appendix.
plies r1 r2 r3 r4 . Also, note that our assumption Having resolved the ambiguity that arises when both
of no free disposal is never binding, except possibly barter and cash are available, we can now derive the
when π0 0, and even then only if γ 0.5 More im- Bellman equations. Again, let time proceed in discrete
portantly, there are equilibria where π 0 and γ 0;
exchange despite its storage cost. We will have more 5 To be precise, we should say what agents do after dis-
to say about the economics underlying the above re- posing of their money. We assume here that they cannot
trade, as they cannot produce. Hence, agents will dispose of
sults in the next section, after we introduce a slight money and drop out of the trading process iff V1 0. Since it
variation on the model, since it will be interesting to is easy to see that V0 0 in any equilibrium and V1 V0 in any
compare the two versions. equilibrium with π0 0, the only case where disposal could po-
FIGURE 1
Game Tree
Accept (u–c, u–c)
1–ψ1
Cash Accept (∆1,∆0)
Buyer proposes
β Reject (0,0)
Reject (0,0)
(7) V1 c V1
rτ
1
yπ 1 γ
1 M u V0 V1
ατ 1 M 1 y xπ u V0
y π M V1
(10) rV0 yu c 1 V0 c
1 ατ xy ατ 1 M 1 y xπ V1
1
ατ xy u c V0
1 rτ
ατ M 1 y xπ V1 c
Proposition 3. In the alternative model, where agents
1 ατ xy ατ M 1 y xπ V0 with money can produce, there are five potential types
parameter space:
where we temporarily reintroduce α x to facilitate com- 1. π0 1 and π1 0 is an equilibrium iff r r̂2
parison to equations (1) and (2) in the previous model.
Observe, for example, that now a money holder barters 2. π0 0 and π1 1 is an equilibrium iff r r̂3
every time he encounters a double coincidence, which
occurs with probability ατ xy. Indeed, he uses money 3. π0 1 and π1 0 1 is an equilibrium iff r̂1
r r̂4
which occurs with probability 1 M π .
M 1
y u
u Can Produce
r̂2 γ u
r̂3 γ c r
r4 r3
γ 1 M 1 y u c
r̂4
c
Cannot Produce
r1
πo = 1
r r苵4 r苵3 π1 = 0
π1 = 1
or
π 1 (0,1)
∋ πo = 1
π1 = 0
γ
–(1–M)(1–y)(u–c) 0 M(1–y)(u–c)
π o = 0,
πo = 0 πo = 1
or πo = 1
π1 = 1 π o (0,1)∋ π1 = 1
where the unique equilibrium is π 1, as well as other
π1 = 1 r苵2
regions where there are multiple equilibria: In one re-
gion, we must have π1 1, but π0 can be 0, 1, or be-
tween 0 and 1; in another region, we must have π0 1,
while π1 can be 0, 1, or between 0 and 1.7
r苵1
πo = 1 The models differ in that it is actually more difficult
π1 = 0 to get money to circulate when money holders can pro-
π1 = 1
or duce; the potential region where π 0 is larger when
π1 (0,1)
∋ πo = 1
libria exist in the two models (those where money ition is as follows: When money holders can produce,
holders cannot produce and those where they can pro- there is no cost associated with acquiring money when
duce) are shown in figures 2 and 3. The same five types we set γ c 0, so if there is a strictly positive prob-
of equilibria exist in both models; the regions where ability of money being accepted, you should always
they exist are similar but quantitatively different— accept it. This is not true when money holders can-
unless y 0, of course, since the models are identical
when there is no barter. In either case, when γ is very
low the only equilibrium is one in which no one ac- 7 It is well known that there is a strategic complementarity
cepts money; if γ is very high, the only equilibrium is in the decision to accept money, π0 , but it is less well under-
stood that the same is true of π1 . For some parameters, an
one in which no one spends it. Hence, money circu- agent is more willing to spend money if he believes that oth-
lates if and only if its intrinsic properties are not too ers will do the same. This only occurs when γ 0.
not produce, because even when γ c 0, accepting the exchange process even though money “crowds out”
money involves the opportunity cost of giving up your barter.
barter option.
The version of the model in which agents with FIGURE 4
money cannot produce is easy to motivate by saying
that one must consume before producing, since this Welfare as a Function of M
leads naturally to the result that agents in equilibrium
always hold either 0 or 1 unit of money. However, rW
S
the alternative version where money holders can pro- rW1
duce also seems more natural in some respects. For K
rW1
example, when two agents with money meet and there
is a double coincidence, they trade. Of course, this
version does require assuming directly that agents can S
rWπ
only store 0 or 1 units of money. There is not neces-
sarily a right or wrong model, and the choice should K
be dictated by how well it addresses a certain question rWπ
and how tractable it is in any given application.
rW0S
IV. Welfare
In this section, we discuss welfare, defined by W
MV1
rW S y M 1 M 1 yπ u c
where the superscript K indicates the case where This discussion ignores the fact that π 1 is not an
money holders cannot produce and the superscript S equilibrium for all parameter values. If γ 0, it is easy
indicates the case where they can. Notice first that to see that in either version of the model, π 1 is an
when we compare two equilibria in either model, other equilibrium if and only if M M 1 1 yrcu c . The
things being equal, W is greater in the equilibrium with true optimal policy, then, is the minimum of M and the
the higher π . This simply says that the more accept- values given above. In figure 4, we depict welfare in
able money is, the more useful it is. The next thing to each type of equilibrium by the curves W0j , Wπj , or W1j ,
notice is that across the two models, given any π we where money is accepted with probability 0, π , or 1.
have W S W K with strict inequality as long as y 0
The superscript j K or S refers to the two different
and M 0; not surprisingly, agents are better off if we
models. The curves are drawn only for values of M
allow money holders to produce. such that the equilibria exist. Figure 5 shows welfare
We now want to focus on equilibrium with π 1 as a function of y, given that we set M to its welfare-
and consider maximizing W with respect to M. The re- maximizing level (which depends on y). These figures
sult for the model in which money holders can produce illustrate various properties, including: W is always
1
is M 2 . The intuition is simple. Money is useful higher when money holders can produce; and W in-
because it facilitates trade every time an agent i with creases with π across equilibria in either model.
money and an agent j without money meet and iWj
holds. To maximize the frequency of such meetings,
we should have half the agents holding money and half V. Essentiality of Money
of them not: M 12 . For the other model, the welfare-
At this stage, it is instructive to highlight the role
maximizing policy is M 12 2y 2y if y
1
2 , and M 0 of various frictions in the model, to understand what
1
if y 2 . Hence, the optimal M is lower in this model, makes money essential. Following Hahn (1965), we
simply because when money holders cannot produce, say money is essential if it allows agents to achieve al-
increasing M “crowds out” barter. Still, for small y the locations they cannot achieve with other mechanisms
welfare-maximizing M is positive because it facilitates that also respect the enforcement and information con-
17
plifies to r r̃
1 y u c c. As always, if
is pure barter. But if there is money, we can do better
n 1 mod 3 . If all agents meet at the same place than pure barter, even when trading histories are pri-
vate. Notice that monetary exchange generates lower different ways. A typical approach is the generalized
welfare than the credit arrangement, although higher Nash bargaining solution,
than pure barter.
θ
(13) q arg max u q V0 Q T1
cq
T0
u 0 c 0 0, u q 0, c q 0, u q 0, and e Q
q q* q1
q
c q
0, for q 0, with at least one of the weak
produce the right good, they bargain over how much q The bargaining solution in equation (13) defines a
will be exchanged for the buyer’s unit of money, im- mapping q q Q from 0 q̂ into itself. That is,
Shi (1995) and Trejos and Wright (1995) analyze the case
(11) rV1 1 M u Q V0 V1
(12) rV0 M V1 V0 c Q
for the model where money holders cannot produce. Ru-
pert, Schindler, and Wright (forthcoming) consider the general
case.
These can be easily solved for V1 V1 Q and V0
a bargaining problem. In equilibrium, of course, q lying strategic model; see Osborne and Rubinstein (1990) for
Q. The bargaining model can be formulated in several the bargaining theory.
19
unit of money, then a particular pair bargaining bi- along. Since he discounts the future, a seller is only
laterally will agree to q q Q . An equilibrium is a
willing to produce less than the amount that satisfies
fixed point, q q Q . In general, we must be care- u q
c q . Indeed, to verify that frictions are driv-
possibility of binding constraints. The constraints can sible to have ∂ qe ∂ M 0 for small M (at least if r is
also small). The explanation is that when M is close to
DQ V1 Q V0 Q . The former constraint is satis-
zero, very little trade occurs. In this case, increasing
fied if and only if q f Q , and the latter is satisfied if
M increases the frequency of productive meetings be-
and only if q g Q , for increasing functions f and g.
tween buyers and sellers, which in turn increases both
As figure 6 shows, both f and g go through the origin V1 and V0 . The net effect on the bargaining solution
in the Q q plane, and g lies below f and below the can be a higher q. However, there is some threshold
M̂ 12 such that ∂ qe ∂ M 0 for all M M̂, so we
can be sure that the value of money eventually begins
can be constrained to the interval 0 q1 .
to fall as M increases.
The first-order condition for an interior solution to We can also ask how M affects welfare. It is clear
equation (13), taking V1 V0 Q and V0 V0 Q as
that if a planner can choose both M and q to maximize
given, is W , he will choose M 12 and q q . This is because
M 12 maximizes the number of trades (just as in the
V1 Q cq u q uq V0 Q c q 0
written as q Q
and q Q
∂ qe
M 1 M u q c q 0
we have
(14) rW M 1
M uq
cq
etary equilibria, while for small r there are multiple monetary
equilibria.
that qe q also can be shown for models where agents can
ceeds from production consist of cash that can only be hold any amount of money; see Trejos and Wright (1995, pp.
spent in the future when an opportunity to buy comes 133–4).
20
(15) V1 V0 cq r 1 M cq 1 M uq γ
c q
currency. In the previous section’s model, this imme- Any bounded, non-negative path for q solving the
diately implies V0 0 by virtue of equation (12), so above differential equation constitutes an equilibrium.
we have V1 c q . Inserting this into equation (11)
we have FIGURE 7
(16) rc q
1
M uq
cq
Dynamic Equilibria
•
An equilibrium is a q that solves equation (16). Al- q
though the model with take-it-or-leave-it offers is in-
teresting in its own right, mainly because of its sim-
plicity, we use it here to study dynamics. •
q = F (q)
We need to rederive the Bellman equations without
limiting our attention to steady state. First, write the
discrete time value of holding money at t as
–γ
1
ατ 1 M xπ u τ
V1 t V0 t
rτ
1
1 ατ x 1 M π V1 t τ γτ oτ
V1 t τ V1 t oτ
γ
τ τ
(17) rV1 t αx 1 M πu V0 t V1 t
V0 t
cq
Note that because of equation (15), the first term on there is an equilibrium that converges monotonically
the right side of equation (18) is 0. up to qL ; for all q0 qL qH , there is an equilibrium
Henceforth, we will omit the time argument t when that converges monotonically down to qL . The former
there is no risk of confusion. Then an equilibrium is a
bounded time path for each of the variables V0 V1 q
(latter) equilibria are characterized by deflation (infla- high-storage-cost goods are used as money. Aiyagari
tion), due simply to beliefs. If agents expect prices to and Wallace (1991, 1992) generalize this to N types
change, this can be a self-fulfilling prophecy. When and consider several applications. Wright (1995) ex-
γ 0, qL coalesces with the nonmonetary equilibrium tends the model to allow agents to choose their type.
q 0. Hence, in addition to the steady states, the set Renero (1994, 1998b, 1999) considers several exten-
of equilibria includes paths starting at any q0 0 qH
sions of the framework. Among other things, he shows
and converging down to q 0. that equilibria in which goods with high storage costs
serve as money can have good welfare properties, per-
haps surprisingly (the intuition is that there is more
VIII. Extensions and Related Literature trade in such equilibria). Other related papers include
In this section, we provide a short overview of some Kehoe, Kiyotaki, and Wright (1993), Cuadras-Morato
extensions to and applications of the above models and Wright (1997), and Renero (1998a).
in the literature. We will discuss some of the papers There is also a literature on search models with pri-
briefly; others we will merely mention. Our intent is vate information. Williamson and Wright (1994) as-
to provide a bibliography rather than a review, so that sume there is uncertainty concerning the quality of
the interested reader at least knows where to look.16 goods. In such an environment, a generally recog-
The basic search-theoretic monetary model can be nizable money has the potential role of mitigating the
generalized along several dimensions. Specialization informational frictions and inducing agents to adopt
is endogenized in more detail in Kiyotaki and Wright strategies that increase the probability of acquiring
(1993), Burdett, Coles, Kiyotaki, and Wright (1995), high-quality output. So money may be valued even if
Shi (1997b), and Reed (1999), for example. More the double-coincidence problem vanishes (that is, even
general production structures are incorporated in Kiy- if y 1).
otaki and Wright (1991) and Johri (1999). Long-term Trejos (1997) presents a simplified version of the
partnerships, in addition to one-time exchanges, are model (essentially by setting y 0), which allows him
considered in Siandra (1996) and Corbae and Ritter to obtain analytical solutions to the model. Kim (1996)
(1997). Various extensions of bargaining are consid- endogenizes the extent of the private information prob-
ered by Engineer and Shi (1998, 1999), Berentsen, lem. Cuadras-Morato (1994) and Yiting Li (1995b)
Molico, and Wright (forthcoming), and Jafarey and use a version of this model to study commodity money.
Masters (1999). We already mentioned credit in sec- All the above papers assume indivisible goods. Tre-
tion II, and there are several papers that attempt to jos (1999) combines private information with divisi-
have money and credit in the model at the same time: ble goods and bargaining. Velde, Weber, and Wright
Kocherlakota and Wallace (1998) assume histories are (1999) and Burdett, Trejos, and Wright (forthcoming)
imperfectly observed over time; Cavalcanti and Wal- use commodity money models with private informa-
lace(1999a,b) and Cavalcanti, Erosa, and Temzelides tion to study some issues in monetary history, includ-
(1999) assume that the histories of only some agents ing Gresham’s Law. Other related papers include Wal-
are observed; and Jin and Temzelides (1999) assume lace (1997b), Williamson (1998) and Katzman, Ken-
only histories of local neighbors are observed. Follow- nan, and Wallace (1999).
ing Diamond (1990), some papers have bilateral credit Several papers attempt to model policy as follows:
and money, with repayment (explicitly or implicitly) There is a subset of agents who are subject to the
enforced by collateral. These include Hendry (1992), same search and information frictions as everyone else
Shi (1996), Schindler (1998), and Yiting Li (forthcom-
ing).
but act collectively. Call these agents government will find something he likes. The Shevchenko and Li
agents. The idea is to see how government agents’ papers also endogenize the number of intermediaries
exogenously specified trading rules affect the endoge- in the economy by means of a free entry condition.
nously determined equilibrium behavior of other (pri- See also Camera (2000), Camera and Winkler (2000),
vate) agents. Papers in this group include Victor Li and Hellwig (2000).
(1994, 1995a), Ritter (1995), Aiyagari, Wallace, and The framework’s most important recent extension
Wright (1996), Aiyagari and Wallace (1997), Li and is perhaps the relaxation of the strong assumptions on
Wright (1998), Green and Weber (1996), Wallace and how much money agents can hold—typically, zero or
Zhou (1997), and Berentsen (2000). For example, in one unit of money, as we assume above. Models that
Victor Li (1994, 1995a, 1997), government agents can consider such an extension can be an order of magni-
tax money holdings when they meet private agents. A tude more complicated, but they are obviously more
key result is that taxing money holdings may be ef- realistic and generate many interesting new results.
ficient. The reason is that in his model (which also They are also capable of addressing more traditional
endogenizes search intensity) there is too little search policy questions, such as the optimal rate of inflation,
by agents holding money, for standard reasons. Taxing which are difficult to study in models where agents
them increases their search effort, and this can improve hold only zero or one unit of money. Such a model
welfare. is contained in Molico (1999), who allows agents to
The matching model seems a natural one for study- hold any nonnegative amount of money and to bargain
ing issues related to international monetary economics. over the quantity of goods as well as the amount of
For example, one can think about parameterizing dif- money that is traded in each bilateral meeting. Be-
ferences in the efficiency of economic activity as well cause of the model’s complexity, however, it can only
as degrees of openness across countries in terms of ar- be solved numerically. The numerical analysis gener-
rival rates. Among the first authors to analyze this in a ates interesting results on policy, welfare, the equilib-
model with multiple currencies and multiple countries rium distribution of prices, and other issues.
are Matsuyama, Kiyotaki, and Matsui (1993). They Green and Zhou (1998b) and Zhou (1999) also
find that several types of equilibria can arise, includ- present a model with divisible money, where several
ing those in which one currency circulates only lo- results can be derived analytically. Unlike Molico,
cally while another emerges as an international cur- they assume that sellers set prices and cannot observe
rency; they find other equilibria in which all currencies buyers’ money holdings. Although such an environ-
are universally accepted. They compare these equi- ment could still have equilibria with a distribution of
libria in terms of welfare. Zhou (1997) extends their prices, they only look for equilibria where all sellers
model to study currency exchange. These models as- set the same price. Several interesting results emerge,
sume indivisible goods. Trejos and Wright (1999) en- including the existence of multiple (indeed, a contin-
dogenize prices using divisible goods and bargaining. uum of) steady states, indexed by the nominal price
Other examples of models with multiple currencies in- level. Also, there can be an endogenous upper bound
clude Kultti (1996), Green and Weber (1996), Craig for money holdings: Agents with sufficient cash will
and Waller (1999), Peterson (2000), and Curtis and not accept more. (Molico’s model can also generate
Waller (2000). this.) Related references are Green and Zhou (1998a),
Some papers consider intermediation (in the form of Zhou (1998), Camera and Corbae (1999), Taber and
middlemen, for example) as an alternative (or some- Wallace (1999), Berentsen (1999a,b), and Rocheteau
times in addition) to money. An early paper to explic- (1999). Shi (1997a) presents an analytically solvable
itly consider intermediation in a search model with- model with perfectly divisible money, but his model is
out money is Rubinstein and Wolinsky (1987). They quite different in some dimensions from the rest of the
generate a role for middlemen by specifying exoge- literature.17
nously a set of agents who may have a more effi- There are other applications and extensions that can-
cient technology for finding buyers than sellers have not all be considered in this brief review. However,
for finding buyers. Yiting Li (1998) is a very different
model, in which private information about the qual-
IX. Conclusion
In this paper, we have presented simple versions of the
basic search-theoretic models of monetary exchange.
Even these simple models allow a variety of questions
to be addressed, and there are a wide range of exten-
sions and applications. We hope this illustrates the use-
fulness of the framework for monetary economics and
will encourage the reader to pursue these issues fur-
ther.
24
y1 M 1 β ψ1 1 β ψ0 1 ψ0 ∆ 1 γ
yM β ψ1
1
β ψ0 u
c
then determine the region of parameter space in which Since we are in case (ii), we have ∆1 0, ∆0 u c
fying, we have
Now ∆0 0 implies
(20)
rc γ
π0 γ 1 yM y1 M 1 β
ru u c
y
ψ0
1 M u c
y1 M 1 β u c
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