The Short-Run Monetary Equilibrium with Liquidity Constraints

Mierzejewski, Fernando (2007): The Short-Run Monetary Equilibrium with Liquidity Constraints.

Abstract

A theoretical framework is presented to characterise the money demand in deregulated markets. The main departure from the perfect capital markets setting is that, instead of assuming that investors can lend and borrow any amount of capital at a single (and exogenously determined) interest rate, a bounded money supply is considered. The problem of capital allocation can then be formulated in actuarial terms, in such a way that the optimal liquidity demand can be expressed as a Value-at-Risk. Within this framework, the monetary equilibrium determines the rate at which a unit of capital is exchange by a unit of risk, or, in other words, it determines the market price of risk. In a Gaussian setting, such a price is expressed as a mean-to-volatility ratio and can then be regarded as an alternative measure to the Sharpe ratio. Finally, since the model depends on observable variables, it can be verified on the grounds of historical data. The Black Monday (October 1987) and the Dot-Com Bubble (April 2000) episodes can be described (if not explained) on this base.

• Item Type: MPRA Paper
• Language: English
• Keywords: Money demand; Monetary equilibrium; Economic capital; Distorted- probability principle; Value-at-Risk
• Subjects: G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E41 - Demand for Money

References

[1] Dhaene, J., Denuit, M., Goovaerts, M., Kaas, R. and Vyncke, D., 2002. The Concept of Comonotonicity in Actuarial Science and Finance: Theory. Insurance: Mathematics & Economics 31 (1), pp.3-33. [2] Dhaene, J., Goovaerts, M. and Kaas, R., 2003. Economic Capital Allocation Derived from Risk Measures. North American Actuarial Journal 7 (2), pp.44-59. [3] Dhaene, J., Kukush, A. and Myhailo, P., 2006. On the Characterization of Premium Principles with respect to Pointwise Comonotonicity. Theory of Stochastic Processes 12 (28), pp. 27-45. [4] Goovaerts M.J., Van den Borre E. and Laeven R., 2005. Managing economic and virtual economic capital within financial conglomerates. North American Actuarial Journal 9 (3), pp.77-89. [5] Howells, P. and Bain, K., 2005. The Economics of Money, Bankig and Finance. Prentice Hall. [6] Hull, J.C., 2000. Options, Futures and Other Derivatives. Fourth Edition. Prentice Hall. [7] Keynes, J.M., 1937. The General Theory of Employment. The Quarterly Journal of Economics 51 (2), pp. 209-223. [8] Merton, R.C., 1997. A model of contract guarantees for credit-sensitive, opaquemfinan- cial intermediaries. European Finance Review 1 (1), pp.1-13. [9] Miller, M.H., 1998. The Modigliani-Miller Propositions After Thirty Years. Journal of Economic Perspectives 2 (4), pp.99-120. [10] Modigliani, F., 1977. The Monetarist Controversy or, Should We Forsake Stabilization Policies? The American Economic Review 67 (2), pp. 1-19. [11] Modigliani, F. and Miller, M.H., 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review 48 (3), pp. 261-297. [12] Sharpe, W.F., 1966a. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance 19 (3), pp. 425-442. [13] Sharpe, W.F., 1966b. Mutual Fund Performance. The Journal of Business 39 (1), pp. 119-138. [14] Tobin, J., 1958. Liquidity Preference as Behavior Towards Risk. The Review of Economic Studies 25 (2), pp. 65-86. [15] Venter, G., 1991. Premium Calculation Implications of Reinsurance without Arbitrage. Astin Bulletin 21 (2), pp. 223-230. [16] Wang, S., 1995. Insurance pricing and increased limits ratemaking by proportional hazards transforms. Insurance: Mathematics & Economics 17 (1), pp. 43-54. [17] Wang, S., 1996. Premium Calculation by Transforming the Layer Premium Density. Astin Bulletin 26 (1), pp. 71-92. [18] Wang, S., Young, V. and Panjer, H., 1997. Axiomatic characterization of insurance prices. Insurance: Mathematics & Economics 21 (2), pp. 173-183.