Our Model and Our History
We designed our model to help us understand problems with the arrangements for minting more or less full-bodied coins that prevailed for centuries throughout western Europe. Our model ascribes rules for operating the mint that copy historical ones, and focuses on the difficulty those rules create for simultaneously maintaining two commodity currencies. The model extends insights from single-currency commodity money models,1 where minting and melting points impose bounds within which the price level must stay to arrest arbitrage opportunities. In those one-commodity money models, when the price level falls enough (i.e., when currency becomes scarce), new coins will be minted; and when the price level rises enough, coins will be melted.2
With two currencies, there are distinct melting and minting points for each currency, and this causes trouble. We posit a particular model of demand for coins that, in conjunction with the two sets of melting and minting points, makes shortages of the smaller denomination coins arise when national income fluctuates. We analyze the perverse price adjustments fostered by the historical supply arrangement, how they served to aggravate shortages over time, and how they left debasement as the preferred relief.
The vulnerability to recurrent shortages of small coins that characterized the historical supply arrangement eventually prompted its repair in the form of a huge “once-and-for-all debasement” of small coins, making a permanent system of token small change. In that system, the government acts as a monopolist for small coins. It can peg the exchange rate of small for large coins, either by always choosing a proper quantity of small ones, or by maintaining convertibility.
Establishing a system of token small change was a fateful step on the road to creating a fiat money system for all currency. As we have seen, refining the idea of fiat money and actually implementing it took centuries. Historical episodes, such as that in Castile in the seventeenth century, highlight the difficulty of establishing a token system even for small coins in the face of technological limits on making coins and persistent pressures on governments to raise revenues from the money supply mechanism.
1 See Sargent and Smith (1997).
2 Sargent and Smith (1997) analyze two-commodity monies in the form of gold and silver coins, but do not link these metals to denomination as we do here. In particular, they have no counterpart to our constraint (21.3).