North - Holland MONEY IN A THEORY OF FINANCE

The title of this essay is taken, of course, from the Gurley/Shaw (1960) monograph to remind the reader at the outset that the objective of constructing a unified theory of money and finance is an old one, one that has challenged theorists at least since J.R. Hicks's (1935) "Suggestion." That the attainment of this objective is still regarded as part of an agenda for future research suggests that there must be something difficult about the problem that earlier writers either did not see or did not adequately face. This paper is an attempt to identify this difficulty and to offer one way of dealing with it. If it is easier today than it was in 1960 to identify exactly in which respects the theory of finance fails as monetary theory, this is largely due to rapid recent progress in the theory of finance. Theoretical research in finance is now conducted almost entirely within the contingentclaim general equilibrium framework introduced by Arrow (1964) and Oebreu (1959). This is not an historical statement, for each of the three pillars of modern financial theory--portfolio theory, the Modigliani-Miller Theorem, and the theory of efficient markets--was discovered within different (and mutually distinct) theoretical frameworks, but all three have since been reformulated in contingent-claim terms, and it was this reformulation that revealed their essential unity and set the stage for many further theoretical advances. This paper begins in Section II with a review of a simple version of the Fisherian model of real capital theory in contingent-claim terms and a review of the relationship of this model to various aspects of financial economics. A central feature of this model is that alI trading occurs in a