A Search Model of the Aggregate Demand for Safe and Liquid Assets∗

Safe and liquid assets, such as Treasury bonds, are money-like instruments that command a convenience yield. We analyze this in a search model of two assets that differ in liquidity and safety. In contrast to the reduced-form approach, which puts the safe and liquid asset in utility function, we explicitly model investors’ trading needs and the trading friction. One new insight from this approach is that the marginal investor’s preference for safety and liquidity is no longer enough in determining the premium. Instead, the distribution of investors’ preferences plays a direct role. The model implies that an increase in the supply of Treasury securities decreases the credit spread of investment-grade bonds, but increases the spread between investment-grade and junk bonds. JEL Classification Numbers: G11, G23.