Illiquid Financial Markets and Monetary Policy

TL;DR

This paper develops a dynamic model linking monetary policy, asset prices, and welfare in illiquid markets with search frictions, highlighting how money facilitates portfolio rebalancing and influences asset prices.

Contribution

It introduces a unified framework combining models of illiquid assets and search-theoretic monetary exchange, establishing conditions for monetary equilibrium and deriving explicit asset pricing implications.

Findings

Asset prices stay above fundamental values, reflecting liquidity premiums.

Higher inflation correlates with lower equilibrium asset prices.

Money's role is crucial in portfolio rebalancing in illiquid markets.

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.