Monetary Theory in the Laboratory

S EPTEMBER/OCTOBER 1998 John Duffy is an assistant professor of economics at the University of Pittsburgh and a visiting scholar at the Federal Reserve Bank of St. Louis. The author thanks Jack Ochs, Michael Pakko, and Joseph Ritter for helpful comments, Nick Meggos for research assistance, and Denise Hazlett and Shyam Sunder for permission to reproduce figures from their papers. that the scale of macroeconomic phenomena Monetary is perceived to be too great to be tested in controlled laboratory experiments with small Theory in groups of subjects. That would almost cer- tainly be the view, for example, among the Laboratory applied macroeconomists working with field data. Today, however, most macroeco- John Duffy nomic theorists work with models that build on explicit microfoundations for the behavior of individuals. These models often INTRODUCTION impose artificial restrictions on individuals’ behavior that are not embodied in any avail- uring the past few decades, an able field data. Consequently, it often is not increasing number of economists possible to empirically test the aggregate Dhave begun conducting controlled predictions that emerge from these models. laboratory experiments with paid human Even in those cases where the aggregate subjects in an effort to test theories of eco- predictions of microfoundation models can nomic behavior. Economists have turned be tested using field data, it is not always to laboratory experiments because in many possible to use field data to verify whether instances they lack the appropriate nonex- behavior at the individual level adheres to perimental field data that are required to the predictions or assumptions of these models. test their theories. Economic experiments On the other hand, controlled labora- usually involve groups of subjects, tory experiments can be used to test both typically college students, who play simple the aggregate and individual predictions of economic decision-making games and are microfoundation models. Though econo- paid on the basis of the decisions they mists need to be wary of generalizing from make. The games subjects play and the the results of laboratory experiments that monetary rewards they can earn in the involve small groups of subjects to aggre- experiment are constructed in a manner gate macroeconomic activity, there should that approximates the theoretical environ- be somewhat less objection to using exper- ment being studied so that the data iments to test the predictions of individual collected from the experiment can be used behavior in macroeconomic models with to prove or disprove the theory. explicit microfoundations. Because the To date, the experimental methodology predictions of these macroeconomic has been used primarily by microeconomists models stand on their assumptions of how and game theorists to test theories of indi- individuals behave, laboratory evidence vidual or strategic behavior in various can test the reasonableness of a particular economic environments.1 Using laboratory model as a characterization of some experiments, researchers have made substan- macroeconomic activity. And in the tial inroads in these fields; microeconomists increasing number of macroeconomic and game theorists now readily acknowledge models that admit multiple equilibria, the relevance of using experiments to test laboratory evidence can be used to guide theory and have begun to develop new theo- researchers toward those equilibria that ries to explain experimental findings that subjects perceive as more relevant. Finally, are at odds with existing theories. macroeconomists can use laboratory By contrast, there has been relatively methods to conduct policy experiments 1 For a recent survey, see, for little use of the experimental methodology that would be impossible to conduct out- example, Kagel and Roth in macroeconomics. A likely explanation is side of the laboratory. (1995). F EDERAL RESERVE BANK OF ST. LOUIS 9 S EPTEMBER/OCTOBER 1998 For these and other reasons, a few Money as a Store of Value researchers have begun to use laboratory For money to serve as a store of value, experiments, as well as survey questionnaires, economic agents must believe that money to test both the assumptions and predictions will have value in the future. A necessary of modern macroeconomic models. This condition for such a belief is that there be paper describes some of these studies, a future. Suppose it was known that the focusing on laboratory tests of various dif- world would end at a certain future date. ferent models of money.2 Though the Would individuals continue to hold money? major emphasis is on the results obtained According to economic theory, no rational from laboratory studies of monetary theo- individual would choose to hold money ries, some attention is also devoted to the day before the world ended, as money issues of experimental design. would be worthless the next day. By the same kind of logic, no one would choose to hold money two days before the world ended, and THE ROLES AND TYPES therefore no one would choose to hold money OF MONEY three days before the world ended, and so Monetary theorists have no single uni- on. This argument, based on backward fied theory of money and do not appear induction, implies that if the end of the world close to achieving any kind of consensus were known with certainty, individuals on what a reasonable theory might entail. would cease holding money. Do human Instead, there are several different and subjects behave in accordance with this 2 competing models of money. Each model prediction? This is a good example of a Some of this literature is also can account for some, but not all, of the question that is difficult to address outside discussed in surveys by Marimon (1997), Ochs important roles that money plays in the of a controlled laboratory setting. (1995), and Sargent (1993). economy. In reviewing laboratory tests of these theories it is useful to organize the 3 While there have been many discussion around the three major roles of Testing Backward Induction experiments involving tests of money. Money serves as a store of value, as McCabe (1989) conducted an experi- backward induction, (see, for a medium of exchange, and as a unit of ment that attempted to test for backward example, Smith, Suchanek, 3 and Williams [1988] and account. Money is a store of value because induction. In his experiment, a population McKelvey and Palfrey [1992]), it is believed to retain purchasing power of players is divided up equally into three McCabe’s (1989) is the only over time. Money is a medium of exchange types. The players then engage in a simple one to consider whether sub- because it is readily accepted in exchange trading game that lasts six rounds. In each jects apply backward induction for goods or services. Finally, money is a round of this game, two of the three player in assessing the value of money. unit of account in that prices of goods and types are endowed with a unit of a good that 4 Wallace (1998) proposes that services are quoted all in terms of units yields a cash payoff at the end of the money should not be a primi- of money. round, but which ceases to have any value tive in theories of money. In In the discussion that follows, we will in the following round. One can think of experimental tests of monetary also make reference to two different types these goods as perishable, like fish or theories there is a similar dic- of money: fiat money and commodity money. bananas. Furthermore, one out of every tum: The goods that are candi- Fiat money is unbacked, intrinsically worth- three players also possesses a ticket that dates to play the roles of less liabilities issued by the government can be used to buy one unit of any perish- money should not be referred to and declared money by the government’s able good. Tickets are not perishable and as money; this prevents fiat power. Dollar bills are an example of can be potentially used over and over triggering any preconceived fiat money. Commodity money is an again to purchase perishable goods. Like notions that experimental sub- intrinsically valued good, the value of fiat money, these tickets have no intrinsic jects might have regarding the proper role of a money object. which serves as the value of money. Gold value—they yield no cash payoff to their 4 Hence McCabe and other exper- coins are an example of commodity holders. In every round of the game, a imenters testing theories of money. Most of the experimental studies of ticket holder may use a ticket to buy one money use more neutral terms money have focused on fiat money because unit of any good, but only if there is another like tickets to refer to objects that is the type of money most commonly player willing to sell a good for a ticket. that may serve as money. used in the world today. Barter exchanges of goods for goods are not F EDERAL RESERVE BANK OF ST. LOUIS 10 S EPTEMBER/OCTOBER 1998 allowed. All offers and exchanges are made players do not have sufficient experience with anonymously through a centralized clearing- the implications that a finite horizon has for house (the experimenter). After any the value of their fiat money holdings. exchanges occur, players are paid the cash Though subjects clearly failed to apply value of any goods they are holding at the backward induction, there are certain end of the round. The cash value from features of McCabe’s experimental environ- holding goods varies in a systematic way ment that may have served to promote the over the six rounds of the game and always use of tickets as a store of value. In particular, differs across the three player types.

Load more