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

89 Pages Posted: 9 May 2014 Last revised: 20 Sep 2014

See all articles by Ricardo Lagos

Ricardo Lagos

New York University (NYU) - Department of Economics

Shengxing Zhang

London School of Economics (LSE) - Department of Economics

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Date Written: September 19, 2014

Abstract

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.

Keywords: Money; Liquidity; OTC markets; Asset prices; Fed model; Financial crises

JEL Classification: D83, E31, E52, G12

Suggested Citation

Lagos, Ricardo and Zhang, Shengxing, Monetary Exchange in Over-the-Counter Markets: A Theory of Speculative Bubbles, the Fed Model, and Self-fulfilling Liquidity Crises (September 19, 2014). Available at SSRN: https://ssrn.com/abstract=2434496 or http://dx.doi.org/10.2139/ssrn.2434496

Ricardo Lagos (Contact Author)

New York University (NYU) - Department of Economics ( email )

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Shengxing Zhang

London School of Economics (LSE) - Department of Economics ( email )

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United Kingdom

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