Introducing Money into the Framework of a General Equilibrium Model

Abstract

Money is an important factor in economic activities but in a general equilibrium framework the concept of money seems to be absent. In fact money is often considered only as a ‘veil’ in hiding real economic activities, and therefore it has been ‘lifted’ out of the model so that the underlying ‘real’ activities in an economy can be examined more clearly. However, in practice, money is more than just a ‘veil’. It can provide a platform on which many activities and/or commodities can be conceived, produced and exchanged. Money is also a store of value, not of its own, but of others, and with its purchasing-power money can enable its holder to have access to, and command the usage of, many other commodities and labour (human-time) to achieve certain objectives. Money therefore can be considered as part of the infrastructure of an economy which helps the economy to grow and prosper. In the past, economic theories of money and theories of (labour and commodity) values have looked at these two sides of an economy as though they are governed by different ‘laws’, but in fact, there is only one set of laws which govern both the price of money as well as the values of commodities and labour. Since money can act as a means of exchange, it therefore can also act as a constraint on this exchange. This means conceptually and mathematically, the ‘value of money’ is actually just the Lagrangian shadow price of this monetary constraint, but expressed in terms of the values of commodities and labour (not in terms of the ‘value of money’ itself, otherwise this is circular reasoning). If a ‘real’ economy is considered as though consisting of many different value-chains linking all activities together from producers to consumers, then money can act as the shadow price level of all these activity-chains. In this paper, we examine the interactions between the different value-chains and their shadow prices, in a general equilibrium economic model. Since monetary exchange is actually at the core of almost every economic activity in a modern economy, a study of the nature and ‘values’ of these exchanges is important for a better understanding of the working of a ‘real’ economy, and the theory of general equilibrium is a useful foundation or platform on which to conduct this study.