Illiquid Financial Markets and Monetary Policy

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, G arleanu, 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