Inside and outside fiat money, gains to trade, and IS-LM (Q1404130)

This is a consistent investigation devoted to building a one-period general monetary equilibrium model. The paper considers a scalar measure \(\gamma(x)\) of the real gains to trade available in a multiple-good economy, whose agents have the endowment \(e\), the outside money \(m\), and can borrow the inside fiat money \(M\) from a central bank. Then a monetary equilibrium exists in which money has a value whenever \(\gamma(e)> m/M\), i.e. the ratio \(m/M\) is less than the value of the gains to trade available at autarky. The main results of the paper concentrate within the analysis of two models: (1) A stripped-down one-period model in which a central bank injects a fixed stock \(M\) of inside money into the end of the period. The Treasury branch of the government does nothing else but give a fixed stock of outside money free and clear to households, who treat it as part of their endowment. (2) In the second model, the Treasury is fleshed out when giving the government five policy instruments: the stock of bank money, the supply of government bonds, lump sum transfer to households, expenditures on inputs for the production of public goods, and ad valorem taxes. The hyperinflation is interpreted now in terms of the government deficit as follows: (a) If the Treasury deficit is a finite threshold, hyperinflation sets where the prices go to infinity and trade crashes. (b) In the Treasury runs a large budget surplus, it will push the economy into a liquidity trap where the interest rate is zero, and where small changes in government monetary policy have no effect whatsoever. The effects of the government's policy tools on aggregate nominal variables can be completely described by a graphical framework nearly identified to the IS-LM (incomespending and money market clearing equations) curves introduced by Hicks to illustrate Keynes' general theory. This fact shows that there is nothing incompatible between IS-LM and full market clearing, multiple commodities, and heterogeneous households. The effects of government policy on welfare, consumption, and price levels is also described, and the paper proves that in terms of real variables, the five policy instruments achieve nothing more than it is available by using any two of them, e.g. the combination of open market operations and government spending on commodities by printing money.