An examination of fiat money as a mechanism for solving coordination problems in decentralized markets

Abstract

Trade developed through barter, an institution requiring the double coincidence of wants. Fiat money subsequently arose to provide traders with a mechanism for exchange in decentralized markets while avoiding the problems associated with commodity monies. Currently, every major modern economy uses fiat money and numerous Internet economies are developing private fiat monies, yet traditional economic theories, such as general equilibrium or Walrasian models, provide little insight. This work develops the concept of a coordination equilibrium model, which maintains fiat money's role as a medium of exchange. The potential instability of fiat money is apparent from observed hyperinflationary episodes. Civil unrest and real purchases financed by printing money are also associated with hyperinflations. These factors lead to an experimental design addressing the stability of intrinsically valueless money. Via controlled laboratory experiments, subjects trade fictitious commodities for fiat money in a circular flow economy. The experimental results indicate that under a long trading horizon with no money creation, fiat money provides a stable medium of exchange and the economy realizes almost maximum efficiency, a result consistent with the coordination equilibrium model but not with standard economic models. Shortening the trade horizon causes a decrease in efficiency. However, the ability to create money leads to hyperinflationary trade patterns independent of the horizon. Further, the experimental results demonstrate that the collapse is not caused by an increasing money supply but rather the result of interference in the real price discovery process. As the party issuing money is often an active participant, this economic instability creates a problem in the design of decentralized economic systems. Forcing the monetary authority to balance fiscal spending with the level of tax collection is a potential solution. Experimental evidence demonstrates that a balanced budget results in a pattern of market activity similar to that observed in fiat money economies when the government is inactive. This level of trade is achieved by private agents "crowding out" the government. Further, this effect is not due to the introduction of inside money, money that derives value within the system as tender for tax payment.