Heterogeneous Asset Valuation in OTC Markets and Optimal Inflation

Abstract

Building on recent work in monetary theory and finance, we develop a framework where money serves a double liquidity role, namely, it serves as a medium of exchange in goods markets as well as asset markets. We argue that studying such a framework is not only more empirically relevant, but also gives rise to new, important economic insights regarding the effects of inflation on welfare and asset prices. The main result of the paper is that, contrary to conventional wisdom, in our model welfare can be increasing in inflation due to a new channel whereby higher inflation promotes beneficial trade in the secondary asset market.

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

JEL Classification: E31, E50, E52, G12