Money and capital as competing media of exchange

We construct a model where capital competes with fiat money as a medium of exchange, and we establish conditions on fundamentals under which fiat money can be both valued and socially beneficial. When the socially efficient stock of capital is too low to provide the liquidity agents need, they overaccumulate productive assets to use as media of exchange. When this is the case, there exists a monetary equilibrium that dominates the nonmonetary one in terms of welfare. Under the Friedman Rule, fiat money provides just enough liquidity so that agents choose to accumulate the same capital stock a social planner would. ∗We thank Randall Wright and seminar participants at the Australian National University, University of Paris 2, University of Sydney and the 2003 Meetings of the Society for Economic Dynamics. Lagos thanks the C.V. Starr Center for Applied Economics at NYU for financial support. Rocheteau has benefitted from the Summer Research Grant scheme of the School of Economics of the Australian National University. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Minneapolis or the Federal Reserve System.