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

Working Paper No. 21528 We develop a model of monetary exchange in over-the-counter markets to study the effects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by particip...

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Bibliographic Details
Published in:NBER Working Paper Series 2015-09, p.21528
Main Authors: Lagos, Ricardo, Zhang, Shengxing
Format: Article
Language:English
Subjects:
Analysis
Economic models
Economic theory
Equilibrium
Equity
Inventory
Investors
Liquidity
Monetary policy
Over the counter trading
Political economy
Price levels
Prices
Stocks
Studies
Treasury bonds
Valuation
Yield
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Summary:Working Paper No. 21528 We develop a model of monetary exchange in over-the-counter markets to study the effects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by participating in the market-making activity and by holding asset inventories on their own account. The theory predicts that asset prices carry a speculative premium that reflects the asset's marketability and depends on monetary policy as well as the microstructure of the market where it is traded. These liquidity considerations imply a positive correlation between the real yield on stocks and the nominal yield on Treasury bonds---an empirical observation long regarded anomalous. The theory also exhibits rational expectations equilibria with recurring belief driven events that resemble liquidity crises, i.e., times of sharp persistent declines in asset prices, trade volume, and dealer participation in market-making activity, accompanied by large increases in spreads and abnormally long trading delays.
ISSN:0898-2937
DOI:10.3386/w21528