Creator: Lagos, Ricardo and Rocheteau, Guillaume Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 408 Abstract:
We develop a search-theoretic model of financial intermediation and use it to study how trading frictions affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. A distinctive feature of our theory is that it allows for unrestricted asset holdings, so market participants can accommodate trading frictions by adjusting their asset positions. We show that these individual responses of asset demands constitute a fundamental feature of illiquid markets: they are a key determinant of bid-ask spreads, trade volume, and trading delays—all the dimensions of market liquidity that search-based theories seek to explain.
This paper is an extension of Ricardo Lagos’s work while he was in the Research Department of the Federal Reserve Bank of Minneapolis.
Keyword: Execution delay, Liquidity, Search, Trade volume, and Bid-ask spread Subject (JEL): D10 - Household Behavior: General and D83 - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
Creator: Lagos, Ricardo and Rocheteau, Guillaume Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 375 Abstract:
We investigate how trading frictions in asset markets affect portfolio choices, asset prices and efficiency. We generalize the search-theoretic model of financial intermediation of Duffie, Gârleanu and Pedersen (2005) to allow for more general preferences and idiosyncratic shock structure, unrestricted portfolio choices, aggregate uncertainty and entry of dealers. With a fixed measure of dealers, we show that a steady-state equilibrium exists and is unique, and provide a condition on preferences under which a reduction in trading frictions leads to an increase in the price of the asset. We also analyze the effects of trading frictions on bid-ask spreads, trade volume and the volatility of asset prices, and find that the asset allocation is constrained-inefficient unless investors have all the bargaining power in bilateral negotiations with dealers. We show that the dealers’ entry decision introduces a feedback that can give rise to multiple equilibria, and that free-entry equilibria are generically inefficient.
Keyword: Execution delay, Liquidity, Search, Asset prices, Trade volume, and Bid-ask spread Subject (JEL): G21 - Banks; Depository Institutions; Micro Finance Institutions; Mortgages, G11 - Portfolio Choice; Investment Decisions, and G12 - Asset Pricing; Trading Volume; Bond Interest Rates
Creator: Lagos, Ricardo and Rocheteau, Guillaume Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 342 Abstract:
This paper studies the effects of anticipated inflation on aggregate output and welfare within a search-theoretic framework. We allow money-holders to choose the intensities with which they search for trading partners, so inflation affects the frequency of trade as well as the quantity of output produced in each trade. We consider the standard pricing mechanism for search models, i.e., ex post bargaining, as well as a notion of competitive pricing. If prices are bargained over, the equilibrium is generically inefficient and an increase in inflation reduces buyers’ search intensities, output and welfare. If prices are posted and buyers can direct their search, search intensities are increasing with inflation for low inflation rates and decreasing for high inflation rates. The Friedman Rule achieves the first-best allocation and inflation always reduces welfare even though it can have a positive effect on output for low inflation rates.
Keyword: Trade surplus, Velocity of money, Inflation rates, Terms of trade, Prices, Trade gains, and Cash Subject (JEL): E40 - Money and Interest Rates: General and E50 - Monetary Policy, Central Banking, and the Supply of Money and Credit: General
Creator: Lagos, Ricardo and Rocheteau, Guillaume Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 341 Abstract:
We construct a model where capital competes with fiat money as a medium of exchange, and we establish conditions on fundamentals under which fiat money can be both valued and socially beneficial. When the socially efficient stock of capital is too low to provide the liquidity agents need, they overaccumulate productive assets to use as media of exchange. When this is the case, there exists a monetary equilibrium that dominates the nonmonetary one in terms of welfare. Under the Friedman Rule, fiat money provides just enough liquidity so that agents choose to accumulate the same capital stock a social planner would.
Keyword: Fiat money and Commodity money Subject (JEL): E52 - Monetary Policy, E42 - Monetary Systems; Standards; Regimes; Government and the Monetary System; Payment Systems, and E41 - Demand for Money