Monetary Exchange in Over-the-Counter Markets: A Theory of Speculative Bubbles, the Fed Model, and Self-fulfilling Liquidity Crises

Abstract

Lagos thanks the support from the C.V. Starr Center for Applied Economics at NYU. Zhang thanks the support from the Centre for Macroeconomics at LSE. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

Centralized Trading of Corporate Bonds

“…Compared to our framework, an increase in the bargaining power of financial intermediaries coincides with a decrease in the bargaining power of agents who want to sell bonds. Similar to Lagos and Zhang (2015), we find that such a shift in bargaining power generally reduces asset prices; however, we also show that it improves welfare. Furthermore, Lagos and Zhang (2015) mainly focus on asset pricing, while we focus on the optimal design of the market structure; i.e., whether centralizing the secondary financial market proves effective in improving welfare compared to an over-the-counter structure.…”

“…Concretely, Lagos and Zhang (2015) assume that agents do not directly trade with each other, but that they trade with a financial intermediary which has access to a competitive interdealer market. The authors find that the higher the bargaining power of financial intermediaries, the lower the asset prices become.…”

Monetary Policy and Efficiency in Over-the-Counter Financial Trade

“…As pointed out by Lagos and Zhang (2015), the negative relationship between asset prices and the nominal interest rate (i.e., the holding cost of money) reported in parts (b) and (under some extra conditions) (c) of Proposition 2 is well documented in the data and often considered anomalous. Although both papers offer a theory that can rationalize this regularity, it should be noted that the channels that give rise to this result in the two frameworks are very different.…”

“…Other recent papers also incorporate secondary asset market trade within a monetary search model. Examples include Geromichalos and Herrenbrueck (2012), Berentsen, Huber, and Marchesiani (2014), Trejos and Wright (2014), Lagos and Zhang (2015), Mattesini and Nosal (2015), and Geromichalos and Jung (2015). Our paper is the first among this literature to introduce OTC market entry decisions and to study how inflation can affect these decisions and, consequently, welfare.…”

“…Furthermore, we find that a higher inflation typically decreases asset prices because it depresses equilibrium real balances and makes sellers more willing to give away their assets at a cheaper price. As pointed out by Lagos and Zhang (2015), such a negative relationship between asset prices and the nominal interest rate (i.e., the holding cost of money) is well-documented in the data and often considered anomalous. 3…”