Is Why We Use Money Important?

Victor E. Li
Economic Review, Vol. 86, No. 1, 2001

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Money and its underlying function as a medium of exchange play a central role in determining the course of macroeconomic activity. However, many of the models used to evaluate fundamental questions relating money and monetary policy to economic activity simply assume currency is valued and overlook the important properties of money that influence the way it is used and how its supply affects the economy.

Search and matching models of money identify the characteristic assumptions for motivating the use of money in carrying out transactions by explicitly capturing the trade frictions that cause money, rather than some form of barter, to be used. This article summarizes some of the recent literature on search models of money and their successful application to issues such as currency substitution and the impact of money's quantity and growth rate on inflation and economic activity.

This promising class of models, the author concludes, does indeed shed light on these topics and has an enormous potential to address an even broader range of issues. To date, the results of most of these applications have been qualitative. In future work, a quantitative analysis would explore not only how well these models explain the empirical facts regarding money and economic activity but might also provide guidelines for the operation of monetary policy.

March 2001