Illiquid Financial Markets and Monetary Policy

Athanasios Geromichalos, Juan M. Licari and José Suárez-Lledó

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Abstract: This paper analyzes the role of money in asset markets characterized by search frictions. We develop a dynamic framework that brings together a model for illiquid financial assets `a la Duffie, Garleanu, and Pedersen, and a search-theoretic model of monetary exchange `a la Lagos and Wright. The presence of decentralized financial markets generates an essential role for money, which helps investors re-balance their portfolios. We provide conditions that guarantee the existence of a monetary equilibrium. In this case, asset prices are always above their fundamental value, and this differential represents a liquidity premium. We are able to derive an asset pricing theory that delivers an explicit connection between monetary policy, asset prices, and welfare. We obtain a negative relationship between inflation and equilibrium asset prices. This key result stems from the complementarity between money and assets in our framework.

Date: 2019-09
New Economics Papers: this item is included in nep-dge, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:1909.01889

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