The Price Theory of Money, Prospero's Liquidity Trap, and Sudden Stop: Back to Basics and Back

Guillermo Calvo

No 18285, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Fiat money contains the seeds of its own destruction. It has no intrinsic value and, yet, it can be exchanged for valuable consumption and production goods. As Hahn (1965) shows, this situation puts fiat money's market value or liquidity premium at the brink of collapse. In this paper I will argue that (1) sticky prices, especially when staggered, provide output backing to fiat money, helping to sustain fiat money's liquidity premium and, thus, lowering the risk of a liquidity meltdown. I call this view the Price Theory of Money; (2) fixed-income assets linked to fiat money, especially if they are perceived to have low counter-party risk (like US Treasury bills, AAA bonds or Asset-Backed Securities) can take advantage of point (1) to become quasi-moneys; (3) this gives incentives to the private sector to create those assets; (4) however, unless protected by a Lender of Last Resort, the new assets' liquidity premium can quickly and massively evaporate in what I call (with a wink to the Bard) a Prospero's Liquidity Trap; (5) the latter lowers the market value of loan collateral and clogs the credit channel, bringing about a credit event or Sudden Stop, with severe output and employment consequences.

JEL-codes: E31 E41 E44 E58 F31 F41 F42 (search for similar items in EconPapers)
Date: 2012-08
New Economics Papers: this item is included in nep-mac and nep-mon
Note: IFM
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Citations: View citations in EconPapers (7)

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