Cash in Advance Money Bonds Model

Cash in Advance Money Bonds Model

Today’s topic is cash in advance money bonds model…In order to create a positive demand and positive value for money in the presence of bonds that yield a higher return, we need to add assumptions that allow fiat money to possess a correspondingly higher liquidity than bonds. We sketch below one possible set of such
assumptions.

Assume that:
(i) The individual’s lifetime is now divided into T +1(T greater than 0) lifestages from 0 to T.
(ii) Purchases of either commodities or bonds require the prior possession of money.
(iii) Bonds have a minimum maturity of one period and cannot be cashed before maturity.
(iv) There is no resale market in bonds.
(v) Commodities and bonds trade only against money, but not against each other.
(vi) Only one transaction can be conducted between commodities and money, or between
bonds and money, in a period. That is, commodities cannot be exchanged against bonds, or vice versa, in the same period but both can be
exchanged against prior money holdings.

Cash in Advance - Distinction Between Money And Bonds
Cash in Advance – Distinction Between Money And Bonds

Distinction Between Money And Bonds

The requirement that individuals must pay in money (labeled in this part of the literature as “cash,” though this term is meant to include bank deposits) for their purchases of commodities and bonds is known as the cash in advance or Clower constraint, and is a fundamental
requirement of a monetary economy. As pointed out earlier, it is part of the environment of the modern economy. The above assumptions imply that money is more liquid, in the sense of being useable for purchasing commodities in the period after its acquisition, while
bonds cannot be so used; bonds cannot be cashed until the period after their acquisition and the funds thus obtained can only be used to buy commodities one period later.

Intuitively, in the model being set up, with the very short durations of periods, the prior holdings of money can be used to buy commodities (and bonds) without further delay while the prior holdings of bonds require a delay of at least one period in purchasing commodities; bonds
converted into money in the current period can only be used to purchase commodities in the next period. Hence, money is more liquid than bonds, so that the preceding assumptions serve our purpose of introducing a liquidity difference between money and bonds in the economy.

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