Bargaining, Trust and the Role of Money

Abstract

It is widely acknowledged that the incorporation of money into the Arrow-Debreu model is problematic. Hahn (1965, 1973), for instance, showed that every economy possessing an equilibrium with positively valued money also had an equilibrium in which money had zero value, and since money induced no efficiency gains, it had no essential role within the model. The purpose of the current paper is to analyze a distinctive role for money in which money performs an essential service of contract enforcement within a trustless environment. Building on the work of Gale (1978, 1982), the paper specifically examines whether the (Pareto-efficient) allocation in a trustworthy exchange economy can be reproduced in a trustless economy through the introduction of money. In the absence of money, the trustless economy is characterized by a state of autarky. After taking the strategic decisions of agents into account, the analysis isolates general conditions in which the trustless monetary economy reproduces the allocation of the trustworthy exchange economy. Hence money is shown to be a welfare-improving device. In Gale's approach, intertemporal barter trade opportunities exist in an economy with complete trust but are non-existent in an economy