GENERAL ECONOMIC EQUILIBRIUM WiTH INCOMPLETE MARKETS AND MONEY

In the prevailing theory of economic equilibrium with incomplete markets, assets pay in “units of account” which are regarded as money but have no link to the actual currencies that rule in financial dealings. The units of account at any given time are unrelated to those at another time or in another state, as if the money in question must be disposed of and reissued in a separate form in any transition. In consequence, there is a fundamental indeterminacy in prices which precludes inflationary comparisons and the handling of multiple currencies with market-generated exchange rates. Here, a model is developed that remedies these shortcomings through innovations in “goods” and the way agents can get utility from them. A new approach to time, states, and prices helps by loosening the grip of perfect foresight in the interpretation of future spot markets. A single currency, which can be fiat money, denominates all units of account. Such money, as a special “good,” is supported in value by the utility agents attach to retaining it. That utility derives from Keynesian considerations and liquidity, and is balanced in equilibrium against the future interest earned in compensation for temporarily giving up access to money. Other “goods” may stand for bonds or equities. All two-party financial contracts can be viewed in this framework as concerned with deliveries of “goods.” Moreover the amounts delivered can depend on future prices, so that diverse types of options can now be covered. Endogenously introduced transaction costs on issuing contracts keep markets from getting out of hand and lead to bid-ask spreads which, in particular, induce a gap in interest rates for lending and borrowing money. On the technical side, equilibrium is given a formulation in variational analysis which brings new tools to the subject and offers better prospects for stability studies and computation. By taking advantage of money and a fresh way of proving existence, this formulation also succeeds, where traditional fixed-point reductions would not, in drastically weakening the survivability assumptions on initial endowments.