We compare three market structures for monetary economies: bargaining (search equilibrium); price taking (competitive equilibrium); and price posting (competitive search equilibrium). We also extend work on the microfoundations of money by allowing a general matching technology and entry. We study how equilibrium and the effects of policy depend on market structure. Under bargaining, trade and entry are both inefficient, and inflation implies first-order welfare losses. Under price taking, the Friedman rule solves the first inefficiency but not the second, and inflation may actually improve welfare. Under posting, the Friedman rule yields the first best, and inflation implies second-order welfare losses. Copyright The Econometric Society 2005.

We develop a search-theoretic model of financial intermediation and use it to study how trading frictions affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. A distinctive feature of our theory is that it allows for unrestricted asset holdings, so market participants can accommodate trading frictions by adjusting their asset positions. We show that these individual responses of asset demands constitute a fundamental feature of illiquid markets: they are a key determinant of bid-ask spreads, trade volume, and trading delays-all the dimensions of market liquidity that search-based theories seek to explain.

We construct a model where capital competes with fiat money as a medium of exchange, and we establish conditions on fundamentals under which fiat money can be both valued and socially beneficial. When the socially efficient stock of capital is too low to provide the liquidity agents need, they overaccumulate productive assets to use as media of exchange. When this is the case, there exists a monetary equilibrium that dominates the nonmonetary one in terms of welfare. Under the Friedman Rule, fiat money provides just enough liquidity so that agents choose to accumulate the same capital stock a social planner would.

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This essay surveys the new monetarist approach to liquidity. Work in this literature strives for empirical and policy relevance, plus rigorous foundations. Questions include: What is liquidity? Is money essential in achieving desirable outcomes? Which objects can or should serve in this capacity? When can asset prices differ from fundamentals? What are the functions of commitment and collateral in credit markets? How does money interact with credit and intermediation? What can and should monetary policy do? The research summarized emphasizes the micro structure of frictional transactions, and studies how institutions like monetary exchange, credit arrangements, or intermediation facilitate the exchange process. (JEL E24, E31, E42, E44, E52, G10, G21)

This paper studies the effects of anticipated inflation on aggregate output and welfare within a search-theoretic framework. We allow money-holders to choose the intensities with which they search for trading partners, so inflation affects the frequency of trade as well as the quantity of output produced in each trade. We consider the standard pricing mechanism for search models, i.e. ex-post bargaining, as well as a notion of competitive pricing. If prices are bargained over, the equilibrium is generically inefficient and an increase in inflation reduces buyers' search intensities, output and welfare. If prices are posted and buyers can direct their search, search intensities are increasing with inflation for low inflation rates and decreasing for high inflation rates. The Friedman Rule achieves the first best allocation and inflation always reduces welfare even though it can have a positive effect on output for low inflation rates.

We study the efficiency of liquidity provision by dealers and the desirability of policy intervention in over-the-counter (OTC) markets during crises. We emphasizes two OTC frictions: finding counterparties takes time, and trade is bilateral and involves bargaining.We model a crisis as a shock that reduces investors' asset demands, lasting until a random recovery time. In this context, dealers can provide liquidity to investors by accumulating asset inventories. When OTC frictions are severe, even well capitalized dealers may not find it privately optimal to accumulate inventories, and direct purchase by the government can improve welfare.

We compare three pricing mechanisms for monetary economies: bargaining (search equilibrium); price taking (competitive equilibrium); and price posting (competitive search equilibrium). We do this in a framework that, in addition to considering different mechanisms, extends existing work on the microfoundations of money by allowing a general matching technology and endogenous entry. We study how the nature of equilibrium and effects of policy depend on the mechanism. Under bargaining, trades and entry are both inefficient, and inflation implies a first-order welfare loss. Under price taking, the Friedman rule solves the first inefficiency but not the second, and inflation can actually improve welfare. Under posting, the Friedman rule implies first best, and inflation reduces welfare but the effect is second order. * This paper has benefited from repeated discussions with Ricardo Lagos and Matthew Ryan. We also thank participants at the SED conference in Paris (2003) for useful comments.