Quarterly Review 3312

Asset Prices, Liquidity, and Monetary Policy in the Search Theory of Money

Ricardo Lagos | Consultant

Published July 14, 2010

I present a search-based model in which money coexists with equity shares on a risky aggregate endowment. Agents can use equity as a means of payment, so shocks to equity prices translate into aggregate liquidity shocks that disrupt the mechanism of exchange. I characterize a family of optimal monetary policies, and find that the resulting equity prices are independent of monetary considerations. I also study monetary policies that target a constant, but nonzero, nominal interest rate, and find that to the extent that a financial asset is valued as a means to facilitate transactions, the asset’s real rate of return will include a liquidity return that depends on monetary considerations. Through this liquidity channel, persistent deviations from an optimal monetary policy can cause the real prices of assets that can be used to relax trading constraints to exhibit persistent deviations from their fundamental values.

* Originally presented at the Thirty-fourth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis and published as part of their conference proceedings (Federal Reserve Bank of St. Louis Review, July/August 2010, 92 (4), pp. 303-10). This revised version was concomitantly published in the Quarterly Review.

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