Limited Participation and the Neutrality of Money

M oney is useful in overcoming two types of frictions. First, in barter exchange, money helps to mitigate double-coincidence frictions that arise in developed economies where economic agents are specialized in production and consumption. Second, in trades involving credit, information frictions may imply that one economic agent has difficulty getting another economic agent to accept his or her IOUs in exchange for goods and services. In an economy with monetary exchange, much more can be achieved than in an economy without money. Even so, one of the key lessons of monetary economics is that circumstances exist in which changing the quantity of money will not matter at all for what can be produced and consumed in an economy. For example, governments sometimes engage in currency reforms, particularly in circumstances where there has been a recent history of high inflation. One such instance occurred in January 2005, when Turkey introduced a new Turkish lira, equivalent in all respects to the old Turkish lira, except that one new lira trades for one million old lira. That is, the central bank of Turkey declared itself willing to exchange old lira for new lira at a rate of one million to one. What would be the effects of this? To help frame the problem, suppose that the U.S. government were to announce a currency reform, where a new U.S. dollar was introduced, defined as being equivalent to 10 old U.S. dollars. Suppose also that the Federal Reserve did not otherwise change its behavior. The result would be that the money stock and all prices and wages in terms of the new U.S. dollar would be one-tenth of what they would have been under the old U.S. dollar, and all real economic activity would be unchanged.