LIQUIDITY, PRICES, SEIGNIORAGE, AND THE TRANSITION FROM BARTER TO FIAT MONEY

Abstract

The government-led transition from barter to fiat money and its possible failure are analyzed in the Kiyotaki-Wright model when prices are determined endogenously by the strategic bargaining process. The transition is shown to be more inflationary as the government becomes less patient and less credible. The possibility of breakdown in fiat money due to uncertainty in the size of government and its patience implies longer transition path and higher expected inflation. An application to the transition from local currencies to currency integration shows that local governments are tempted to issue more currency to extract seigniorage from foreign as well as home agents. As long as the degree of economic integration is sufficiently large, an increasing frequency of trading opportunities implies lower price levels and higher welfare relative to the local currency regime. It is when the two countries are fully integrated that the world economy with the unified currency achieves the highest welfare.