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

52 Pages Posted: 26 May 2016

Multiple version iconThere are 2 versions of this paper

Date Written: May 17, 2016

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.

Keywords: monetary-search models, liquidity, asset prices, over-the-counter markets

JEL Classification: E31, E50, E52, G12

Suggested Citation

Geromichalos, Athanasios and Jung, Kuk Mo, Monetary Policy and Efficiency in Over-the-Counter Financial Trade (May 17, 2016). Available at SSRN: https://ssrn.com/abstract=2784109 or http://dx.doi.org/10.2139/ssrn.2784109

Athanasios Geromichalos (Contact Author)

University of California ( email )

Kuk Mo Jung

Henan University ( email )

85 Minglun St. Shunhe
Kaifeng, Henan 475001
China

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