The Theory of Money and Financial Institutions, Volume 1

By Martin Shubik
The MIT Press, 1999

This is the first volume in a three-volume exposition of Martin Shubik's vision of "mathematical institutional mathematics" -- a term he coined in 1959 to describe the theoretical underpinnings needed for the construction of an economic dynamics. The goal is to develop a process-oriented theory of money and financial institutions that reconciles micro- and macroeconomics, using as a prime tool the theory of games in strategic and extensive form. The approach involves a search for minimal financial institutions that appear as a logical, technological, and institutional necessity, as part of the "rules of the game." Money and financial institutions are assumed to be the basic elements of the network that transmits the sociopolitical imperatives to the economy.

Volume 1 deals with a one-period approach to economic exchange with money, debt, and bankruptcy. Volume 2 explores the new economic features that arise when we consider multiperiod finite and infinite horizon economies. Volume 3 will consider the specific role of financial institutions and government, and formulae the economic financial control problem linking micro- and macroeconomics.

Martin Shubik is the Seymour H. Knox Professor of Mathematical Institutional Economics at Yale University.

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Preface

My thoughts about money and financial institutions began in 1960. I tried without success to make progress until the end of 1970, when I decided to abandon my work on money. I decided to devote my time to my second most important project, embedding the Cournot oligopoly model in a fully closed economic system. Much to my surprise, the second problem held the key to the first. The need to build a process model of price formation in a closed economy calls for the invention of money and other financial instruments and institutions. Money provides the extra degree of freedom needed to provide the leeway for disequilibrium in a closed economic system. The understanding of how it’s supply is counted, what are its close substitutes, and what are the forces that control its supply is critical to reconciling the studies of micro- and macroeconomics. The essence of understanding money lies in the dynamics.

Money and financial institutions provide the structure to carry process in a disequilibrium economy. They provide a control and evaluation network for the economy. The development of a theory of money and financial institutions provides the first step toward understanding some of the forces behind economic structure. The future development of economics lies in obtaining insights into the control of process in a world in which evaluation, innovation, and disequilibrium are of central concern.

The development of our understanding of how expectations are formed and how innovation is triggered, or how expertise is developed, is critical to devising a new economic dynamics. In common with basic thought in biology and physics, there is a need to understand mass cell, particle, or agent behavior in a stochastic environment subject to some partially controlling agency governed by feedback. The work here is offered as a step toward shifting the stress from an essentially timeless, institution-free, and process-free economic equilibrium to one where process, time, information, and institutions matter.

Money, like language, is a network phenomenon. Its role cannot be considered in isolation. The simplicity or complexity of its function depends on the body of common knowledge, the shared context perceived by individual agents and the communication net. The value of flat money lies in the dynamics, not in a static timeless equilibrium. It is a property of mass agent stochastic behavior.

The link between optimizing behavior often described in microeconomic theory and evolutionary behavior is provided by "the games within the game." At any point in time the institutions, laws, and customs provide the rules of the game for individuals who tend to behave as local optimizers. But on the larger horizon, the local optimization of the economic agents combined with chance and social, political, and technological process conspire to change the rules of the game.

Volume 1 deals primarily with a one-period approach to economic exchange with money, debt, and bankruptcy. Volume 2 indicates the nature of the new economic features introduced in considering multiperiod finite and infinite horizon economies. A projected Volume 3 considers the specific role of financial institutions and government and formulates the economic financial control problem linking micro- and macro economics. A companion volume with Pradeep Dubey and John Geanakoplos providing a mathematical treatment of strategic market games is projected.