In the field of economics, Léon Walras occupies a prominent place as a pioneer of mathematical economics and the theory of general equilibrium. His general equilibrium economic model is a fundamental pillar of modern economic thought.
In this article, we will explore Walras’ basic model, an exchange economy without production, as well as his later developments attempting to fit money into this framework.
Table of Contents
Money in the general equilibrium model
The basic model that Léon Walras constructs is an exchange economy without production. In this model, different economic actors gather on a market place and present their productions already made.
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Each actor can act as buyer or seller for each category of goods. There is a separate market for each type of good. Walrasian economics only considers exchanges and does not analyze production activity.
A Walrasian auctioneer acts as a market arbiter by setting the equilibrium prices for each good. The equilibrium price is the one that balances supply and demand in each market. All trade then takes place at the equilibrium price.
In this model, time is not taken into account, and trades are assumed to take place instantaneously during the same market session.
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Likewise, the information is considered perfect, because the goods are homogeneous, and the auctioneer provides the relevant information free of charge and accessible to all. In this context, the currency is not necessary to carry out the exchanges.
It suffices to choose one of the goods present on the market as “numéraire,” that is to say as a unit of account, to express the price of each good in unit of a single good, thus simplifying exchanges.
Walras considers that all the conditions of perfect competition are met, and all the markets are simultaneously in equilibrium (general equilibrium). There is therefore no excess demand or supply in any of the markets.
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This Walras law derives from price flexibility, allowing a perfect adjustment between the quantities supplied and demanded by the price mechanism. Thus, to carry out exchanges and reach equilibrium, it suffices that the relative prices of the different commodities be fixed by comparing the quantities supplied and demanded.
These relative prices depend on real variables such as consumer tastes, budget constraints, production costs, etc.
In this framework, the introduction of money and variations in the quantity of money would have no impact on the real magnitudes of the economy, because the relative prices remain unchanged.
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Even if Walras takes more account of money and the rate of interest in the latest editions of his “Éléments d’économie politique pure”, he maintains the dichotomy by asserting that the equation of monetary circulation (the quantity theory) remains independent of the equations determining the real equilibrium of the economy. Thus, we are in the presence of a framework that is both dichotomist and quantitative.
From Walras to Patinkin: the real cash effect
Despite Walras’ advances, some economists questioned the idea of a moneyless economy and attempted to introduce money as part of the general equilibrium model. One such economist is Don Patinkin, who sought to include money using the real-money effect, also known as the Pigou effect.
The real cash balance effect assumes that economic agents want to hold a constant level of cash expressed in real terms, ie monetary assets valued at constant prices.
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Thus, if the general level of prices increases, the agents increase the nominal demand for cash in order to maintain their real level of monetary assets. For example, they may increase the amount of money they hold in a bank account and reduce their demand for consumer goods.
Similarly, when prices fall, agents have excess nominal cash, which they use up by demanding more goods and services.
The real cash effect ends the dichotomy, because changes in the quantity of money that cause the general price level to vary have an effect on the “real” sector of the economy, i.e. demand for goods.
However, some post-Keynesian economists consider that Patinkin did not truly integrate money into the model endogenously, because he did not analyze the impact of money on productive structures.
Conclusion
In conclusion, Léon Walras made economic history with his general equilibrium model. Although his initial model was based on an exchange economy without production and abstracted from money, he laid the foundations of mathematical economics and general equilibrium theory.
Economists like Don Patinkin attempted to fit money into this framework using the real-money effect, but debates around the endogeneity of money and its impact on the economy have continued.
Thus, the question of money and its role in the economy remains a complex and essential subject for understanding the functioning of the economy. The theories of Walras and Patinkin paved the way for exciting debates and subsequent developments in economic thought.