A tractable model of indirect asset liquidity

Abstract

Abstract:Assets have "indirect liquidity" if they cannot be used as media of exchange, but can be traded to obtain a medium of exchange (money) and thereby inherit monetary properties. This essay describes a simple dynamic model of indirect asset liquidity, provides closed form solutions for real and nominal assets, and discusses properties of the solutions. Some of these are standard: assets are imperfect substitutes, asset demand curves slope down, and money is not always neutral. Other properties are more surprising: prices are flexible but appear sticky, and an increase in the supply of indirectly liquid assets can decrease welfare. Because of its simplicity, the model can be useful as a building block inside a larger model, and for teaching concepts from monetary theory.Keywords: monetary-search models, asset liquidity, asset prices, monetary policyRecently, interest has increased in tractable models of asset liquidity that are easy to analyze and can provide benchmarks for understanding the relationship between monetary policy and asset market frictions. For example, Williamson (2012), Andolfatto and Williamson (2015), and Rocheteau, Wright, and Xiao (2014) analyze policy using models in which multiple assets can take the role of a medium of exchange, usually to different degrees, which makes them imperfect substitutes and the question of their relative supplies interesting. Furthermore, a number of recent papers have suggested that the notion of asset liquidity may be the key to rationalizing some long-standing asset pricing-related puzzles (see for example Lagos, 2010, Geromichalos, Herrenbrueck, and Salyer, 2013, and Jung and Lee, 2015. 1The assumption that assets such as US Treasuries or claims to capital serve as media of exchange is popular in monetary theory (going back to Geromichalos, Licari, andSuarez-Lledo, 2007, andLagos andRocheteau, 2008), but is sometimes questioned based on realism. In Geromichalos and Herrenbrueck (2012), we demonstrated that indirect asset liquidity can support many of the same conclusions, while offering an alternative microfoundation of imperfect asset substitutability: in this conception of liquidity, assets are substitutes to money because agents can sell them in a secondary financial market, and thus obtain the money needed to make a purchase. This detail is important because it implies that the structure of financial markets has first-order consequences for the 'moneyness' of different types of assets, and therefore their trading volumes and prices.However, the full version of our model did not admit a closed-form description of the solution. The goal of this essay is to simplify the model in a way which preserves its essential features, but increases its usefulness as a building block for general applications. In addition, we extend the model to the case of nominal bonds. The new model sheds light on some latent results that were not highlighted in the earlier paper: most notably, we show that in contrast to conventional wisdom, an increase in the supply of liquid ...

The strategic determination of the supply of liquid assets

“…In our numerical example, we can see that when α B varies in the range [0.6, 0.8], then the supply of liquid assets (only A in this case), average output, and welfare move in the same direction. However, we know that other outcomes are possible: for example, in Herrenbrueck and Geromichalos (2015) we showed that if u is quadratic and OTC trade is seller-take-all, then output is constant and welfare is monotonically decreasing in the supply of liquid assets.…”

“…For example, consider the corner equilibrium where only the OTC market for asset A is open (or assume for a moment that asset A is the only asset). According to a recent result by Herrenbrueck and Geromichalos (2015) and Huber and Kim (2015), it can be shown that welfare is a decreasing function of the asset supply in a neighborhood ( Ā − ǫ, Ā). Why?…”

“…As opposed to these papers, where assets are liquid because they help agents bypass certain frictions, such as anonymity and imperfect commitment, in decentralized markets (by serving directly as means of payment or as collateral) in our paper liquidity is indirect, as in Geromichalos and Herrenbrueck (2012): Assets are liquid not because agents can use them directly to purchase consumption goods, but because they can sell them in a secondary asset market in order to acquire more money (and in our case this market is OTC). This idea is exploited in a number of recent papers, including Marchesiani (2014, 2015), Herrenbrueck (2014), Mattesini and Nosal (2015), Herrenbrueck and Geromichalos (2015) and Han (2015). This strand of the literature is also related to the work of Lagos and Zhang (2015); however, in that paper agents need money in order to purchase assets (rather than goods) in an OTC financial market.…”

Inside Money, Investment, and Unconventional Monetary Policy

“…However, the focus there lies on the distributional effects of this policy in a model with preference shocks, which is an aspect I abstract from. Furthermore, my article is related to the literature on indirect liquidity (w.g., Herrenbrueck and Geromichalos, 2017) which shows that assets can attain a liquidity premium even if they cannot directly be used as a means of payment, but can be traded on financial markets against cash. I show that a similar mechanism is at play if there are institutions such as banks that can issue liquidity by investing in illiquid assets.…”