Building a Model of Money

IN THIS BOOK we will try to learn about monetary economies through construction of a series of model economies that replicate essential features of actual monetary economies. All such models are simplifications of the complex economic reality in which we live. They may be useful, however, if they are able to illustrate key elements of the behavior of people who choose to hold money and to predict the reactions of important economic variables such as output, prices, government revenue, and public welfare to changes in policies that involve money. We start our analysis with the simplest conceivable model of money. We will learn what we can from this simple model and then ask how the model fails to represent reality adequately. Throughout the book we will try to correct the model's oversights by adding, one by one, the features that it lacks.

To arrive at the simplest possible model of money, we must ask ourselves what features are essential to monetary economies. The demand for money is distinct from the demand for the goods studied elsewhere in economics. People want goods for the utility received from their consumption. In contrast, people do not want money in order to consume it; they want money because money helps them get the things they want to consume. In this way, money is a medium of exchange – something acquired to make it easier to trade for the goods whose consumption is desired.

A model of this distinction in the demand for money therefore requires two special features.