A Competitive Market for Money?

We, here at Economic Forces, talk a lot about competitive markets. We also highlight how worried people are about monopoly and dig into whether there is any reason to worry. But what about something like dollars? To some extent, dollars are issued competitively, as in the case of deposits. However, only the Federal Reserve prints up physical currency. Yet, there is little in the way of public complaints about this. How can we use price theory to think about a competitive money supply? And what are the macroeconomic implications of these price theoretic insights?

In theory, we don’t need money. Trade doesn’t require money. We could always barter. We could always trade entirely on credit. Why do we need to pass some rock or piece of paper or coin back-and-forth?

The answer seems to be that people are evil. Okay, maybe not evil, but certainly not always trustworthy. A system of credit works well when everyone can trust everyone else or when society can sufficiently punish those who go back on their promises. When trade is fairly anonymous or when it is hard to punish people for not delivering on their promise, credit just isn’t feasible.

If credit isn’t feasible, one could always turn to barter. However, barter isn’t really a much better option. Trading goods for other goods is difficult. The transaction costs are high. Some goods aren’t divisible. Sometimes people don’t have anything that you want to purchase or you don’t have anything that they want to purchase.

When barter is costly and people have a hard time committing to future actions, people need to figure out ways to exchange. One way this might be possible is to experiment with a certain type of barter. For example, one might figure out the types of goods that nearly anyone would be willing to accept, even if they just accept it in order to turn around and sell the good to someone else later on. Through this process, certain types of goods will start to emerge as a medium of exchange. The goods that emerge will tend to have certain characteristics. For example, these goods will tend to be portable, recognizable, durable, and divisible. This explains why things like precious metals emerged to fulfill this role.

Once something like a precious metal emerges as a medium of exchange, there needs to be some sort of process of creating a standard unit of measurement, or a unit of account. In other words, suppose that gold is the precious metal that emerges as money. How would you specify prices? You could specify them in ounces, but ounces of what? Gold, you say? But what if I give you an ounce of some kind of gold alloy. Is it really the same if 10% of the gold alloy is made up of gold as it is when 90% of the alloy is made up of gold? Of course not. The value depends on what the gold is mixed with. As a result, people are going to come up with a standardized unit of account. For example, one might define the dollar as 1/20 oz. of gold, where the gold is 9/10 fine. Given this definition, everything can be priced in terms of this standard unit of account known as the dollar.

Okay, so what does this have to do with price theory?

Well, let’s think about supply and demand. When we think about supply and demand, what we are really thinking about are relative prices. The cost of bread is how much of some other good that I have to give up to get the bread (e.g., the cost of bread might be thought of as a 2-liter bottle of Coca-Cola or a half-gallon of milk). Relative prices are what matters for our decision-making. Of course, in reality, changes in dollar prices and changes in relative prices can be the same thing. If there is a drought in Florida that reduces the supply of oranges, the relative price of oranges will go up. But this typically occurs through an increase in the dollar price of oranges.

But think about what happens when the unit of account is defined as a particular quantity of a commodity. Given the definition of the dollar above, one dollar equals 1/20 oz. of gold, 9/10 fine. By definition, this implies that the price of an ounce of gold (of the specified quality) is $20. The dollar price of gold is fixed by the definition of the dollar. Yet, gold is traded independently of its use as a medium of exchange. People buy and sell gold jewelry, for example. Thus, supply and demand should determine the price of gold, but the dollar price of gold is fixed. How can we reconcile that?

This is where an understanding that supply and demand is about relative prices becomes important. While it is true that a change in the supply of or demand for gold will result in a price change, supply and demand really just says that the relative price of gold will change. Typically, this means that the dollar price will change, but in this example, the dollar price is fixed by the definition of one dollar. This means that the dollar prices of all other goods will have to change to clear the market.

Consider the following example. Suppose that there is a gold discovery. Holding everything else constant, this increase in the supply of gold should cause the price of gold to decline. Since the dollar price of gold is fixed, other prices will have to rise to clear the market such that the relative price of gold declines. Furthermore, note that the dollar prices of all other goods have to change such that relative prices between these goods all stay the same since the only thing that changed was the supply of gold. Otherwise, there would be an arbitrage opportunity. If the relative prices of all other goods must stay the same, then the dollar prices of these goods must rise proportionately. Thus, the gold discovery leads to a higher price level. We have generated a macroeconomic implication from our basic understanding of price theory.

The preceding example assumes that all money is some kind of commodity, like gold. However, I started this post by talking about competition among different types of money. What if we consider a world in which people issue competing brands of currency instead of a world with only gold coins?

Let’s think about a world of competitive paper money. If I am an entrepreneur and I want to issue my own paper money, how do I get it into circulation? One way to do this would be to simply print up some of these pieces of paper and try to buy things with them. The success of this type of scheme is dependent on people being willing to accept these pieces of paper as payment.

Conceivably, a network effect is necessary to get these pieces of paper circulating. People will be willing to accept my pieces of paper as payment if they expect that other people will also accept them as payment. This is difficult.

One reason why this is difficult is due to the last period problem. Suppose that there is some date in the future at which people are no longer willing to accept these pieces of paper. In that period, the pieces of paper are worthless. However, that means they are also worthless in the prior period. And that means that they are also worthless in the period before that. Through backward induction, this means that the pieces of paper are worthless today.

This problem doesn’t exist with something like gold. If at some point nobody is willing to accept the gold coins, the gold can just be melted down and sold or consumed.

By the same logic, one way to solve this last period problem is to promise to buy these pieces of paper back for some given quantity of a commodity. For example, a currency-issuing firm might offer to give anyone holding this currency a particular quantity of gold per unit of currency. If, for example, they promise to give these currency holders one ounce of gold in exchange for 20 units of their currency, which they call dollars, this is identical to the gold example that I discussed earlier.

The promise to buy back the currency at a future date alleviates the last period problem and therefore makes it more likely that the currency will circulate.

But doesn’t this create a problem? Shouldn’t we fear inflation from the issuance of this competitive money? For example, we know from price theory that firms maximize their profits when marginal revenue is equal to marginal cost. The marginal cost of producing paper money is approximately zero since it costs the same amount to print a $1 bill as it does to print a $1,000,000 bill. If this is the case, doesn’t this mean that these competitive note issuers will print too much paper money and we end up with inflation?

The answer is no. Here is why. To keep things simple, suppose that all paper money is denominated in dollars and the dollar is defined as a particular quantity of gold. In that case, the price level is determined by the supply and demand for gold, just as it was in the case in which the dollar was some abstract definition for a quantity of gold.

The paper currency itself is actually just a derivative contract. In particular, the way that I have defined them, these paper dollars are just perpetual American-style call options on gold. As long as the issuers of these dollars are committed to redeeming these pieces of paper for gold, as promised, the pieces of paper are “as good as gold.” Just as the issuance of an options contract for a stock does not affect the price of the stock, the issuance of convertible paper money does not affect the value of gold and therefore does not affect the price level. If banks issue too many pieces of paper, they will simply be redeemed for gold.

Nonetheless, there is still competition. If a currency issuer lacks the commitment — or people believe she lacks the commitment — to redeem the pieces of paper for gold, the value of the dollars she issues will be influenced by this lack of commitment. The competitive process works through the exchange rates on these various brands of currency. Issuers that lack commitment will find their notes trade at a discount relative to more reliable brands of notes.

Furthermore, this competitive process reveals that the marginal cost of issuing paper money is not zero after all. These issuers have an incentive to invest in advertising and other methods of communicating their commitment in order to establish a name brand and differentiate their brand of currency from others.

If competition is so great and works the way that I have just described, one might wonder why we don’t observe competition today. Similarly, precious metals played an important role in my discussion, but play no role in the monetary system today. The reason for these changes has to do with the state’s role in the monetary system. The evolution of monetary standards and institutions has been heavily influenced by states, from the monopolization over coinage to the creation of central banks and the monopolization of currency issuance. Nonetheless, there is some level of competition in the production of money. Rather than issuing bank notes that are redeemable for gold, banks now issue deposits redeemable for currency.

Similarly, with the emergence of cryptocurrencies, there is the possibility of competition in currency once again. Of course, these cryptocurrencies would have to be used as media of exchange rather than as speculative assets. One thing to note about cryptocurrencies is that, unlike convertible paper money, they do not solve the last period problem. If there is some future period in which nobody wants to accept bitcoin, then these bitcoins will have no value. They cannot be redeemed for anything. This world is sort of like a world with competing fiat monies. Many argued that this sort of world wouldn’t be possible. However, Ben Klein argued that such a world can exist and outlined how a competitive fiat system would operate. But that is another topic for another day.

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