Does Money Always Make People Happy?

In standard overlapping generations models [e.g. Samuelson(1958), Wallace(1980), Tirole(1985)], the valuation of the intrinsically useless asset, or fiat money, is benign to all agents: every agent in the economy becomes happier when money has positive value than when it does not. As is widely known, markets in some of those economies fail to achieve efficient allocation unless incomes are appropriately transferred across generations. If money is demanded as a store of value, it promotes such transfers and, as a result, improves economic welfare
his paper, however, gives another picture of fiat money not so rosy as the above. In the model of this paper, the valuation of fiat money may be malign to the generations bom in and after the first period. Roughly speaking, this result is brought about by the installation of the following externality in a Wallacian overlapping generations economy: the rate-of-return on physical investment is a decreasing function of the value of money; and dominates the rate of population growth when money is valueless. Owing to the externality, the valuation of money lowers the rate-of-return on physical investment. This implies that the interest rates when money is valued are lower than those when it is not, because arbitrage equalizes the rate-of-return on money with that on physical investment. As the result of this decline in interest rates, the agents except the initial old are worse off when money has positive value.

In this model, the valuation of fiat money is not due to the dynamic inefficiency of nonmonetary economy but to the above-mentioned externality. Notice that money and externality explain each other in this model: the externality is not activated unless money has positive value; at the same time, money cannot have positive value unless the externality is activated. That is, the valuation of fiat money activates the externality, which, in turn, causes the valuation of money by lowering the rate-of-return on physical investment. This is how fiat money is valued in this model. In the following sections the externality is not simply assumed but derived from uncertainty and asymmetric information (moral hazard).

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