A Role of Money in Economies with Transaction Frictions

Abstract

We investigate individual specialization decisions and the problem of moral hazard in a decentralized trading environment. Individuals can reduce production costs by undertaking greater specialization but they are confronted a low probability of double coincidence matches. This paper focuses on two types of economy based on the individuals strategy regarding money acceptance, the pure strategy monetary economy and the mixed strategy monetary economy. In each economy, we derive the optimal degree of specialization and show how it is affected by money supply. When the economy is illiquid, the introduction of money increases specialization and welfare in the pure strategy monetary economy. Since the use of money allows individuals to consume more frequently, money acts as a form of social consumption insurance. In the mixed strategy monetary economy, agents specialize less when money is introduced. Since money does not work as a proper medium of exchange under this strategy, agents internalize that less specialization makes it easier to trade and thus a moral hazard problem does not exist. If a moral hazard problem is not severe, therefore, we conclude that the introduction of money leads to specialization and raises welfare by extending the market. We also provide numerical examples to support our arguments.