Asset Prices in an Exchange Economy with Money and Trade
28 Pages Posted: 3 Mar 2007
Date Written: 2007
We show, in an exchange economy with liquidity constraints, that state prices in a complete markets general equilibrium are a function of the supply of liquidity by the Central Bank. Our model is derived along the lines of Dubey and Geanakoplos (1992). Two agents trade goods and nominal assets (Arrow-Debreu (AD) securities) to smooth consumption across periods and future states, in the presence of cash-in-advance financing costs. We show, with Von Neumann-Morgenstern utility functions and relative risk-aversion greater than 1, that the price of AD securities, are inversely related to liquidity. A closed-from solution is obtained for a CRRA utility function, even when including aggregate uncertainty and different subjective probabilities for the two agents. The upshot of our argument is that agents' expectations computed using risk-neutral probabilities give more weight in the states with higher interest rates. This result cannot be found in a Lucas-type representative agent general equilibrium model where there is neither trade nor money. Hence, an upward yield curve can be supported in equilibrium, even though short-term interest rates are fairly stable, and even in the absence of aggregate uncertainty. The risk-premium in the term structure is therefore a pure liquidity risk premium.
Keywords: cash-in-advance , risk-neutral probabilities , state price , term structure
JEL Classification: E43 ,G12
Suggested Citation: Suggested Citation