Working Paper: NBER ID: w21528
Authors: Ricardo Lagos; Shengxing Zhang
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.
Keywords: Monetary Exchange; Over-the-Counter Markets; Speculative Bubbles; Liquidity Crises
JEL Codes: D83; E31; E52; E58; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| quantity of money (E41) | asset prices (G19) |
| anticipated inflation (E31) | real balances (F31) |
| real balances (F31) | asset allocation (G11) |
| asset allocation (G11) | speculative premium (D84) |
| anticipated inflation (E31) | speculative premium (D84) |
| anticipated inflation (E31) | asset prices (G19) |
| dealer withdrawal (L81) | liquidity crises (G01) |
| liquidity crises (G01) | asset prices (G19) |
| liquidity crises (G01) | trading volumes (G15) |
| liquidity crises (G01) | trading delays (F16) |
| liquidity crises (G01) | spreads (Y60) |