Asset Prices in an Exchange Economy with Money and Trade

28 Pages Posted: 3 Mar 2007

See all articles by Raphael A. Espinoza

Raphael A. Espinoza

International Monetary Fund (IMF)

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall

Date Written: 2007

Abstract

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

Espinoza, Raphael A. and Tsomocos, Dimitrios P., Asset Prices in an Exchange Economy with Money and Trade (2007). Available at SSRN: https://ssrn.com/abstract=966433 or http://dx.doi.org/10.2139/ssrn.966433

Raphael A. Espinoza (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://oxford.academia.edu/RaphaelEspinoza

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 932 (Phone)
+44 1865 288 805 (Fax)

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