Time-varying Elasticity of Substitution in Near-Money Assets

Abstract

This paper explores the modelling of time-varying dynamics of the elasticity of substitution between money and liquid assets considered near-money. The liquidity premium between near-money assets over other safe but illiquid assets can vary with time, depending on economic conditions. The model presented in this paper introduces dynamics into the elasticity of substitution between deposits and near-money assets in order to explicitly capture such variation in the modelling of liquidity premium. Adding an autoregressive structure to the elasticity of substitution accounts for the pattern of expansion and contraction described in the credit markets literature, and yields a more realistic model for the expansion and contraction of liquidity in funding markets. The model is applied to U.S. and Canadian data and is shown to exhibit key economic features with important policy implications for market participants and regulators.

Keywords: Near-money, liquidity, risk, dynamics

JEL Classification: C32, C58, E51, G21, G23