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Liquidity and Asset Prices

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  • Raphael A. Espinoza
  • Dimitrios P. Tsomocos

Abstract

We show in an exchange economy with liquidity constraints that the volume of trade and asset prices depend on both the supply of liquidity by the Central Bank and on the liquidity of assets and commodities. As a result, monetary aggregates are informative for the assessment of economic developments and the conduct of monetary policy. We also show that the positive correlation between state prices and the future spot rate generates a risk-premium in the term structure of interest rates, even in absence of aggregate uncertainty. These results do not obtain in representative agent models but hold in any monetary economy with heterogeneous agents and short-term liquidity effects, where monetary costs act as transaction costs and the quantity theory of money is verified.

Suggested Citation

  • Raphael A. Espinoza & Dimitrios P. Tsomocos, 2008. "Liquidity and Asset Prices," OFRC Working Papers Series 2008fe28, Oxford Financial Research Centre.
  • Handle: RePEc:sbs:wpsefe:2008fe28
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    File URL: http://www.finance.ox.ac.uk/file_links/finecon_papers/2008fe28.pdf
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    References listed on IDEAS

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    1. Min Fan, 2006. "Heterogeneous Beliefs, the Term Structure and Time-varying Risk Premia," Annals of Finance, Springer, vol. 2(3), pages 259-285, July.
    2. Tsomocos, Dimitrios P., 2008. "Generic determinacy and money non-neutrality of international monetary equilibria," Journal of Mathematical Economics, Elsevier, vol. 44(7-8), pages 866-887, July.
    3. Backus, David K. & Gregory, Allan W. & Zin, Stanley E., 1989. "Risk premiums in the term structure : Evidence from artificial economies," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 371-399, November.
    4. Dubey, Pradeep & Geanakoplos, John, 2003. "Monetary equilibrium with missing markets," Journal of Mathematical Economics, Elsevier, vol. 39(5-6), pages 585-618, July.
    5. Raphaël Espinoza & Charles. Goodhart & Dimitrios Tsomocos, 2009. "State prices, liquidity, and default," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 39(2), pages 177-194, May.
    6. Grossman, S J & Melino, Angelo & Shiller, Robert J, 1987. "Estimating the Continuous-Time Consumption-Based Asset-Pricing Model," Journal of Business & Economic Statistics, American Statistical Association, vol. 5(3), pages 315-327, July.
    7. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
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    Cited by:

    1. Charles A. E. Goodhart & Dimitrios P. Tsomocos, 2011. "The Role of Default in Macroeconomics," IMES Discussion Paper Series 11-E-23, Institute for Monetary and Economic Studies, Bank of Japan.

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    More about this item

    Keywords

    liquidity; cash-in-advance constraints; term structure of interest rates;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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