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

Abstract

We develop a monetary model that incorporates Over-the-Counter (OTC) asset trade. After agents have made their money holding decisions, they receive an idiosyncratic shock that affects their valuation for consumption and, hence, for the unique liquid asset, namely, money. Subsequently, agents can choose whether they want to enter the OTC market in order to sell assets and, thus, boost their liquidity, or to buy assets and, thus, provide liquidity to other agents. A unique feature of our model is that inflation affects welfare not only through the traditional channel, i.e., through determining equilibrium real balances, but also through influencing agents' entry decisions in the financial market. We use our framework to study the effect of inflation on welfare, asset prices, and OTC trade volume. In contrast to most monetary models, which predict a negative relationship between inflation and welfare, we find that inflation can be welfare improving within a certain range, because it mitigates a search externality that agents impose on one another when they make their OTC market entry decision.

The strategic determination of the supply of liquid assets

“…But as we have explained, the agent's decision which market to visit is one of the most important economic forces in our model. As another example, some related papers (Mattesini and Nosal, 2015;Geromichalos and Jung, 2016) gain tractability by assuming that asset trade takes place only in OTC markets, and the original asset holdings are given to agents in the CM as endowments, i.e. there is no primary asset market.…”

Inflation and Welfare in a Competitive Search Equilibrium with Asymmetric Information

“…They show that, in contrast to standard Ramsey models, inflation is the most efficient way to tax rents associated to the use of money. Other papers find that deviating from the Friedman rule may be optimal when there are trading externalities (as in Shi 1997) or a congestion effect (as in Rocheteau and Wright 2005, Craig and Rocheteau 2008, and Geromichalos and Jung 2017).…”