A Monetary Approach to Asset Liquidity

This paper o¤ers a monetary theory of asset liquidity— one that emphasizes the role of assets in payment arrangements— and it explores the implications of the theory for the relationship between assets’ intrinsic characteristics and liquidity, and the e¤ects of policy on asset prices and welfare. The environment is a random-matching economy where risk-free bonds coexist with a risky asset, equity, and no restrictions are imposed on payment arrangements. The liquidity di¤erential between bonds and equity results from an informational asymmetry in regard to the fundamental value of equity. The model predicts that the risk-free asset is a strictly preferred means of payment, while equity is partially illiquid. As a consequence, the risk-free rate is below its fundamental value, and the equity premium is positive, provided that the supply of bonds is not too large. This result holds irrespective of the supply of equity and despite agents being risk-neutral. Moreover, the equity premium tends to increase as equity becomes riskier. Finally, an increase in the supply of bonds has a permanent liquidity e¤ect. It raises the risk-free rate, output, and welfare, and it reduces the equity premium. Keywords: search, payments, private information, liquidity, asset prices J.E.L. Classi…cation: D82, D83, E40, E50 This paper has bene…tted from discussions with Ricardo Lagos and Pierre-Olivier Weill. I also thank for their comments and suggestions Murali Agastya, Aditya Goenka, Steve LeRoy, Yiting Li, Ed Nosal, Peter Rupert, Neil Wallace, Asher Wolinsky, Tao Zhu and seminar participants at the Federal Reserve Bank of Cleveland, Hong Kong University of Science and Technology, National Taiwan University, National University of Singapore, Rice University, Singapore Management University, the Southern Workshop in Macroeconomics (Auckland), the University of California at Irvine, the University of Tokyo, the workshop on "Networks and Payments" at the University of California at Santa Barbara, and the 2008 meeting of the Society of Economic Dynamics in Cambridge. E-Mail: [email protected].