Search-theoretic models of monetary exchange are based on explicit descriptions of the frictions that make money essential. However, tractable versions of these models typically need strong assumptions that make them ill-suited for studying monetary policy. We propose a framework based on explicit micro foundations within which macro policy can be analyzed. The model is both analytically tractable and amenable to quantitative analysis. We demonstrate this by using it to estimate the welfare cost of in ‡ation. We …nd much higher costs than the previous literature: our model predicts that going from 10% to 0% in ‡ation can be worth between 3% and 5% of consumption.
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.
I develop an asset-pricing model in which financial assets are valued for their liquidity-the extent to which they are useful in facilitating exchange-as well as for being claims to streams of consumption goods. The implications for average asset returns, the equity-premium puzzle and the risk-free rate puzzle, are explored in a version of the model that nests the work of Mehra and Prescott (1985). * First draft: May 2005. I am indebted to Ellen McGrattan and Fabrizio Perri for many helpful conversations at various stages. I am grateful to Nobu Kiyotaki for his feedback as a discussant at the Princeton-NY Fed Conference on Liquidity and the Philadelphia Workshop on Monetary and Macroeconomics. I thank V.
Search-theoretic models of monetary exchange are based on explicit descriptions of the frictions that make money essential. However, tractable versions of these models typically need strong assumptions that make them ill-suited for studying monetary policy. We propose a framework based on explicit micro foundations within which macro policy can be analyzed. The model is both analytically tractable and amenable to quantitative analysis. We demonstrate this by using it to estimate the welfare cost of inflation. We find much higher costs than the previous literature: our model predicts that going from 10% to 0% inflation can be worth between 3% and 5% of consumption. * First version: May 2000. Many people provided extremely helpful input to this project, including S.
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