The Transition From Barter to Fiat Money

The Mongol IlKhans in Persia, impressed by the use of paper money by their suzerain in China, decided to use the same device themselves.Technical advisers were sent from Peking, and an elaborate organization was set up.The Persians, however, had not been accustomed to the use of paper currency by several hundred years of gradual developments.They simply refused to believe that these nicely printed pieces of paper were worth anything, and the experiment was a failure.(Gordon Tullock, 1957) How did it become possible to exchange apparently valueless pieces of paper-fiat money-for goods, and why did it take so long for pure fiat money to become prevalent, given the obvious benefits to its issuers?The juxtaposition of these questions at first seems paradoxical.This paper argues that the answers to these two questions are fundamentally linked.The first question has occupied monetary theorists for decades, though much of modern monetary theory has avoided it in favor of one that is closely related but more easily answered: Can an artificial economy be structured in a reasonable way so that there are equilibria in which an apparently worthless commodity has a positive price?The second puzzle has received little attention, though on reflection it is striking that widespread use of purely fiat money is a twentieth century development (Milton Friedman and Anna J. Schwartz, 1986), since the idea and physical implementation are simple.This paper presents an explicit solution to the first puzzle in a simple artificial economy.In formal terms I ask whether there is an equilibrium transition path between a barter equilibrium and a steady state monetary equilibrium.The paper also suggests a possible solution to the second, less widely considered puzzle.The answer suggested here is that the money issuer or government must attain a critical level of "credibility" before the transition can take place.Most economists would probably relate a stylized "history of money" something like the following: As specialization caused problems in coordinating trade, societies naturally settled upon certain commodities, usually metals, as media of exchange.Later the minting of a certain quantity of a metal into coin acted as a signal of the quantity and purity of the metal.The signals of standardization needed credibility and the process of standardization