The Hahn problem stands as a profound and frequently ignored embarrassment for monetary economics. Frank Hahn, writing in the 1960s and 1970s, posed an apparently disarmingly simple question: how can money — intrinsically worthless printed paper — possess value in a perfectly competitive general-equilibrium economy? In the mainstream Arrow–Debreu world, individuals hold only assets that yield utility or returns. Fiat money offers neither.
According to the model’s logic, rational actors should reject money, causing its value to fall to zero. However, empirical observation contradicts this, as money in real economies is widely used for transactions, serves as a store of value, and is fundamental to modern exchange. Hahn’s critique thus exposed a fundamental structural incompleteness in the Walrasian framework, which is frequently portrayed as the pinnacle of mainstream economic logic
Mainstream economists responded by scrambling to bolt monetary scaffolding onto the pristine general equilibrium core. Cash-in-advance constraints forced agents to hold money prior to trade; overlapping-generations models created a role for money across time; search-theoretic approaches invoked the double-coincidence problem. In each, money acquires value not because of intrinsic merit, but because the modeller stipulates a world in which trade collapses without it. The Hahn problem thus exposed the theoretical vacuum at the heart of general equilibrium and forced economists, grudgingly or creatively, to concede that money matters.
Dynamic stochastic general equilibrium (DSGE) models claim to have absorbed this lesson, yet they do so in a curiously contrived fashion. The usual solution is to embed frictions that artificially endow money with value. The cash-in-advance device is the workhorse: no money, no purchases. The prevailing solution for modelling money demand is to either treat currency as a direct good in utility functions or to posit unique transaction costs that only money can alleviate. These methodological choices artificially generate a demand for money, which in turn forms the basis for the theory that central banks can manage the economy by manipulating liquidity.
The financial crisis that engulfed mature economies in the late 2000s has prompted much soul searching. Economists are now trying hard to incorporate financial factors into standard macroeconomic models. However, the prevailing, in fact almost exclusive, strategy is a conservative one. It is to graft additional so-called financial “frictions” on otherwise fully well behaved equilibrium macroeconomic models, built on real-business-cycle foundations and augmented with nominal rigidities. The approach is firmly anchored in the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) paradigm.
The flaw is that these explanations are circular. They start by assuming that money has value, which is the very thing they are supposed to prove. If you model an economy without transaction costs or with easy access to credit, the reason for using money vanishes, and the model fails unless you add more artificial rules to prop it up. DSGE models thus offer a tidy mathematical patch, not a genuine resolution. The Hahn problem has not been solved — it has been smothered under assumptions that conveniently deliver the desired conclusion.
Hahn drew attention to this limitation of Walrasian or Arrow–Debreu GE theory but was unable to resolve it and failed to stress its perfect barter implications. Unlike his contemporaries, however, he generally resisted the temptation to succumb to casual empiricism and incorporate money, finance and other features of reality in a model where they were not required …
The misuse of the Walrasian or Arrow–Debreu GE microeconomic foundations, an imaginary world of perfect barter, largely explains why DSGE models proved so inept at understanding or anticipating the GFC and why attempts to now incorporate realistic and relevant features of the financial sector in such models also fail … At the very least, theorists who propose improved versions of these DSGE models must first explain how they ‘solve’ the Hahn problem.
