Monetary Exchange in Over-the-Counter Markets: A Theory of Speculative Bubbles, the Fed Model, and Self-fulfilling Liquidity Crises

Ricardo Lagos and Shengxing Zhang

No 21528, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop a model of monetary exchange in over-the-counter markets to study the effects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by participating in the market-making activity and by holding asset inventories on their own account. The theory predicts that asset prices carry a speculative premium that reflects the asset's marketability and depends on monetary policy as well as the microstructure of the market where it is traded. These liquidity considerations imply a positive correlation between the real yield on stocks and the nominal yield on Treasury bonds---an empirical observation long regarded anomalous. The theory also exhibits rational expectations equilibria with recurring belief driven events that resemble liquidity crises, i.e., times of sharp persistent declines in asset prices, trade volume, and dealer participation in market-making activity, accompanied by large increases in spreads and abnormally long trading delays.

JEL-codes: D83 E31 E52 E58 G12 (search for similar items in EconPapers)
Date: 2015-09
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-mst
Note: AP ME
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Citations: View citations in EconPapers (47)

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