Rudolf Richter o n e y Lectures on the Basis of General Equilibrium Theory and the Economics of Institutions Translated from the German by Wolfgang F. Stolper With 38 Figures Springer-Verlag Berlin Heidelberg New York London Paris Tokyo Hong Kong Professor Dr. Rudolf Richter Department of Economics Universitat des Saarlandes 6600 Saarbrucken 11, FRO Translator: Wolfgang F. Stolper Professor Emeritus Department of Economics University of Michigan Ann Arbor Michigan, USA ISBN-13 :978-3-642-74039-8 e-ISBN-13: 978-3-642-74037-4 DOl: 10.1007/978-3-642-74037-4 Library of Congress Cataloging-in-Publication Data Richter, Rudolf, 1926- [Geldtheorie. English) Money: lectures on the basis of general equilibrium theory and the economics of institutions / Rudolf Richter: translated from the German by Wolfgang F. Stolper. p. em. Translation of: Geldtheorie. Bibliography: p. Includes indexes. ISBN-!3:978-3-642-74039-8 (U.S.) 1. Money. 2. Equilibrium (Economics) I. Title. HG22I.G41313 1988 332.4--dc 19 This work is subject to copyright. All rights are reserved, whether the whole or part ofthe material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in other ways, and storage in data banks. Duplication of this publication or parts thereof is only permitted under the provisions of the German Copyright Law of September 9, 1965, in its version of June 24, 1985, and a copyright fee must always be paid. Violations fall under the prosecution act of the German Copyright Law. © Springer-Verlag Berlin' Heidelberg 1989 Softcoverreprint of the hardcover 1st edition 1989 The use registered names, rademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regula tions and therefore free for general use. Typesetting: ASCO Trade Typesetting Ltd., Hong Kong 2142/7130-543210 To my wife Introductory Remarks Nowadays every exposition of the problems of the money economy should really begin with a theory of price and distribution. 1. A. Schumpeter (1917118, 631; English translation 1956, 150) Economics comes closer to being a 'science of contract' than a 'science of choice'. 1. M. Buchanan (1975, 229) The theory of money is the theory of exchange involving the use of money. Both exchange and the use of money are social phenomena. Both can only be explained within the framework of a social model. For exchange con sidered in isolation there exists such a model: the theory of general equilibrium. As far as the use of money is considered matters are somewhat more complicated. Nevertheless, the theory of general equilibrium is in the process of being supplemented by a theory of ex change by means of money. At the same time, the institutional basis of a money economy, i.e. the economics of institutions, is once again being stressed. However, a systematic joint analysis of both is still missing. This book, too, will not succeed in presenting a complete synthesis. We will, however, try to direct the attention of the reader in this direction. Neoclassical equilibrium analysis will be understood as the ideal result of a specific institutional framework, as a system of consistent contracts bet ween individuals which are carried out exactly. How these contracts are reached will not be analyzed. A stationary equilibrium model will serve as a reference system. Deviations from stationary equilibrium are interpreted as the result of slack within the institutional framework. A description or explanation of the process of adaptation to equilibrium is not of interest in this context. No analysis of market processes will be given. The analysis of evolu tionary processes is confined to the evolution of currency orders where "order" is defined as a system of social norms or rules. Monetary theory is understood as a theory of the currency order. This approach permits not only clearer access to problems of monetary theory, it also gives a total view of monetary theory that is otherwise impossible. The book consists of two parts. Part I presents, in elementary form and tailored to our purposes, the basic skeleton of the theory in so far as it is relevant to our subsequent considerations: general equilibrium theory and the economic theory of institutions. In Part II we develop monetary theory on the basis of these fundamental considerations. Part I consists of three chapters. Chapter 1 presents the general theory of competitive equilibrium for one period. The chapter limits itself to ex change or purchase transactions where both sides of the exchange occur simultaneously. The second chapter deals with the theory of general equilibrium over several periods. Loans in kind and forward purchases are now possible. A model of stationary equilibrium and the theory of VIII Introductory Remarks overlapping generations are presented. The overlapping generations model will later be used as the basic model of monetary theory. Chapter 3 deals with the economic theory of institutions in general, not merely with the theory of the institution of money. The concepts of "property rights" and of "transaction costs" will be introduced. The model of a transactions firm will be described which will be used later to explain the holding of cash balances and the theory of the banking firm. We finally deal with the theory of the market as an institution and, in this context, the concept of a market community. Part II consists of Chapters 4 to 8. Chapter 4 presents approaches to the economic explanation of the institution of money. In the older literature this was called the analysis of the "nature of money", a term which we also will use. We introduce the concepts of a "currency com munity" and of an "elementary currency order". The core of this chapter is the description and economic explanation of the regulatory objects of an elementary currency order. Chapter 5 deals first with the concept of "payment" applied to exchange by means of money. Next we describe an economy without transaction costs. In such an economy the holding of cash balances does not pay even if exchange involves the use of money. Money is "qualitatively" perfectly neutral; that is, it makes no difference whether exchange involves the use of money or not, whether we deal with money purchases or barter transactions, whether loans are made in kind or involve money, or which currency is used in accounting. The conditions of arbitrage equilibria, which playa pervasive role in neoclassical theory, are described; the significance of the arbitrage logic is illustrated. Chapter 6 introduces transaction costs and their effects. We develop a sta tionary overlapping generations model in which the holding of cash balances is worthwhile because the exchange of cash for interest-bearing assets and vice versa involves cost. The quantity theory of money applies: the amount of money and the prices of goods are related in a strictly pro portional manner. Money is "quantitatively" neutral. Chapter 7 deals with problems of the various institutional solutions to the problem of safeguarding the value of money on the basis of the overlapping genem tions model which has been developed in the preceding chapter. The two basic types of a currency order, the commodity standard and the paper standard, are discussed, both for the case of a single country (i.e. on a "na tional" basis) and for the case of two countries (i.e. on an "international" basis). Freely fluctuating exchange rates are discussed in this context, as are the arguments for and against the commodity and the paper standard. Chapter 8 discusses financial intermediaries, particularly banks, using the concept of a "transactions firm" which was introduced in Chapter 3. We return to the problem of how to safeguard the value of money and discuss the problems of public regulation of the central bank and the commercial banks. The book has grown out of a series of lectures which the author gave during the past fifteen years and which he continuously revised. It is a mix ture of monograph and textbook. Its centml idea is the importance of the Introductory Remarks IX currency order. The currency order determines the why and how of the use of money. The individuals who negotiate purchase or loan agreements orient themselves on such an order. It is the currency order which is the basis of the trust in a currency which in turn is the precondition for the pro per functioning of money. It has been our intention to interpret the theory of money as the theory of a currency order. We have done so on the simple assumptions of a stationary overlapping generations model whose primary function has been to help organize our thoughts. We deviate from this model in our interpretations whenever this seems appropriate. We have not tried to formulate an exact model for the economic analysis of institu tions as applied to money. The theory of money is such a vast subject matter that it is impossible to discuss all of the relevant literature even when limiting oneself to a par ticular point of view. On the other hand, an intensive and extensive study of the literature is essential for an understanding of the theoretical topics which we treat. To help the student, we have appended to each chapter sug gestions for further reading together with brief comments. The English version is a translation of the first German edition which went to the printer in January 1987 and which appeared during the sum mer of 1987. The references to the literature have been extended for the English reader, and a few important later contributions have been incor porated. Tables and Charts were updated to 1987 inclusive. Several paragraphs were revised and it is hoped, improved, among them in par ticular the end of Chapter 6. Two errors were corrected: an unjust criticism of Patinkin in Appendix 3 to Chapter 6 which was pointed out to me by U. Schlieper and a wrong subscript in equation (3) of Appendix 1 to Chapter 8 which was discovered by one of my students. This correction made the results of equation (8-3) more complicated and also affected the arguments in Sections 8.2 and 8.4. All told, the English translation may be considered a revised and enlarged second edition of the German book. My debts of gratitude are extensive. My first debt is to the University of the Saarland for maintaining good working conditions despite difficult budgetary problems. The University of Michigan extended two invitations for longer periods as guest professor which were most stimulating and helpful. My thanks are also due to the Deutsche Forschungsgemeinschaft and the Wissenschaftliche Gesellschaft des Saarlandes for financial help with two shorter visits to the USA. To the same foundations, the Fritz Thyssen Stiftung and the Kultusminister of the Saarland go my thanks for providing the major part of the costs of the international seminars on the New Institutional Economics organized by Eirik G. Furubotn and myself which gave me insights into new and interesting directions of research. Mr. Hans Gliem, President of the Landeszentralbank flir das Saarland, and Mr. Herbert Weber, Chairman of the executive board of the Landesbank Saar, Girozentrale, provided contacts with actual practice. Numerous discussions with colleagues of the Faculty of Law and Economics of the University of the Saarland stimulated the work on the manuscript. The discussion of early versions of Chapters 3 and 4 in a x Introductory Remarks working group on law and economics with Georg Rees, Dieter Schmidt chen and Dietrich Schultz should be specially mentioned. It was a beautiful experience. Elke Schafer-Jackel read and criticised in particular early versions of Chapters 2 and 6. Wolfgang Stutzel helped with questions and answers to Chapter 5. My former assistant Peter Dittus discussed with me the various drafts of the last three chapters and the whole conception of the book. I am greatly obliged to Emil Baltensperger, Eva Bossmann, Ekkehard Schlicht and Ulrich Schlieper for critically reading the final version of the manuscript. Individual parts of the manuscript were presented and discussed at Washington University St. Louis, Texas A&M University, Col lege Station, the University of Texas at Arlington and several times at the University of Michigan, Ann Arbor. In this connection lowe particular thanks to Eirik G. Furubotn, Douglas C. North, Steven Wiggins, Aquiles Almansi, David Aschauer and Jeffrey Miron for their critical comments. My friend Wolfgang F. Stolper translated the manuscript from the German, not without frequent substantive objections and proposals for improvement. Occasionally, I have even listened to him - after lengthy and animated discussions. His openness to arguments, patience and labor in tensity deserve many thanks. My assistants and selected graduate students helped in many ways both with the preliminaries and the final version of the German and Eng lish manuscripts. Frank Diener made the calculations and the computer plotted figures and drew the graphs. Ralf Maurer compiled and improved the German manuscript including the list of references. With great pa tience and perseverance Barbara Thimm-Maldener typed the German ver sion and Eva Schneider and Detlef Karges typed the English version. Claudia Korf and Thomas Busch made the index, provided the English references and helped with the final proofs of both versions. David An drews helped with the editing of the English translation and Joan Kmenta with editorial advice. To my wife my thanks are due for her patience, moral support and help with the final work on the manuscript. The English version was finished in March 1988. Rudolf Richter Contents Part I. Theoretical Foundations: An Elementary Overview ..... Chapter I. General Equilibrium Theory: An Outline . . . . . . . . . . . 3 1.1 General Equilibrium Theory Without Production . . . . . 3 1.2 General Equilibrium Theory With Production . . . . . . . . 9 1.3 The Purchasing Power of Money: Definition. . . . . . . . . 15 1.4 The Determination of the Purchasing Power of Money. ... . .. . .... . ... . .... .... .... . .... ... ... . . 17 1.4.1 The Case of a Commodity Standard: The Pure Gold Coin Standard ................................... 18 1.4.2 The Case of a Paper Standard: A Pure Paper Circulation ...................................... 18 1.5 The Classical Dichotomy and the Patinkin Controversy ..................................... 20 Appendix to Chapter 1 ................................. 25 1. The Determination of the Optimal Consumption Plan of a Household .................................. 25 2. The Determination of the Optimal Production Plan of a Firm..... .... ... . .... . .... ... .... . ....... .. 27 3. Walras's Law With Any Number of Households and Firms. ... .... . .... ....... . .... . ....... .... ... . .. 28 Suggested Readings to Chapter 1 ......................... 28 1. Theory of General Equilibrium . . . . . . . . . . . . . . . . . . . . . 28 2. The Purchasing Power of Money ..... . . . . . . . . . . . . . . 29 3. Determination of the Purchasing Power of Money . . . . 29 Chapter 2. Capital Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 2.1 The General Approach .. . . . . . . . . . . . . . . . . . . . . . . . . . . 32 2.2 A Simple Robinson Economy . . . . . . . . . . . . . . . . . . . . . . 33 2.3 Two Present and Two Future Goods: Does "the" Real Rate of Interest Exist? ............................ 43 2.4 The Robinson Economy in Stationary Equilibrium . . . . 45 2.5 The Young and the Old Robinsons: The Stationary Theory of Overlapping Generations . . . . . . . . . . . . . . . . . 50 2.5.1 An Overlapping Generations Model Without Production 50 2.5.2 An Overlapping Generations Model With Production. 55 XII Contents Appendix to Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 The Stationary Rate of Interest May be Different from Zero ....................................... 59 Suggested Readings to Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . 63 1. The Robinson Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 2. The General Case ................................ 63 3. The Optimal Capital Stock of an Economy . . . . . . . . . . 63 4. Two Approaches to Capital Theory ................. 63 5. General Discussion of Capital and Interest Theory. . . . 64 6. The Model of Overlapping Generations ............. 64 Chapter 3. The Economics of Institutions . . . . . . . . . . . . . . . . . . . . 65 3.1 Topics of Modern Institutional Economics .. . . . . . . . . . 65 3.2 What are Transaction Costs? ....................... 69 3.3 Transaction Costs in General Equilibrium Theory: A Simple Example ............................... 73 3.4 Why Economic Institutions? ....................... 81 3.4.1 The Market as an Institution: Auction Markets or Direct Negotiations? ............................. . 82 3.4.2 Why Do Firms Exist? ............................ . 84 3.4.3 Why Relational Contracts? ....................... . 85 3.4.4 Why Public Regulation? .......................... . 86 3.5 General Equilibrium and Institutional Economics: Some Conceptual Considerations .................. . 89 Appendix to Chapter 3 ................................. 92 Utility Maximization of the Household Including Transaction Costs ................................ 92 Suggested Readings to Chapter 3 ......................... 94 1. Property Rights and Transaction Costs in General . . . . . 94 2. Transaction Costs in General Equilibrium Theory . . . . . 94 3. Why Economic Institutions? ....................... 95 a) Auction Markets or Direct Negotiations? ......... 95 b) Why Do Firms Exist? .......................... 95 c) Why Relational Contracts? ..................... 95 d) Internalization of External Effects ...... . . . . . . . . . 95 e) Why Public Regulation? ........................ 96 4. On the Economic Theory of Institutions . . . . . . . . . . . . . 96