Differences of Opinion, Liquidity, and Monetary Policy

Johnson, Christopher (2016): Differences of Opinion, Liquidity, and Monetary Policy.

Abstract

Liquidity considerations are important in understanding the relationship between asset prices and monetary policy. Differences of opinion regarding the future value of an asset can affect liquidity of not only the underlying asset, but also of competing media of exchange, such as money. I consider a monetary search framework in which money and risky assets can facilitate trade, but where the asset is an opinion-sensitive medium of exchange in that traders may disagree on its future price. A pecking-order theory of payments is established between money and risky assets, which can go in either direction depending on the respective beliefs of both agents in a bilateral trade. In short, optimists prefer to use money over assets, whereas pessimists prefer to use assets over money. In contrast to a majority of the differences of opinion literature, not only do pessimists actively participate in the purchasing of assets, but in some cases their demand coincides with that of optimists. Additionally, in support of Bernanke and Gertler (2000), I find that monetary policy aimed at reducing asset price volatility need not be welfare-maximizing. Instead, the Friedman rule is welfare-maximizing.

• Item Type: MPRA Paper
• Language: English
• Keywords: liquidity, monetary policy, asset pricing, differences of opinion
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit

References

S Rao Aiyagari, Neil Wallace, and Randall Wright. Coexistence of money and interest-bearing securities. Journal of Monetary Economics, 37(3):397-419, 1996.

Ben Bernanke and Mark Gertler. Monetary policy and asset price volatility. Technical report, National bureau of economic research, 2000.

John Bryant and Neil Wallace. The inefficiency of interest-bearing national debt. The Journal of Political Economy, pages 365-381, 1979.

Erik Eyster and Michele Piccione. An approach to asset pricing under incomplete and diverse perceptions. Econometrica, 81(4):1483-1506, 2013.

Athanasios Geromichalos and Lucas Herrenbrueck. Monetary policy, asset prices, and liquidity in over-the-counter markets. Technical report, Working Papers, University of California, Department of Economics, 2012.

Athanasios Geromichalos and Ina Simonovska. Asset liquidity and international portfolio choice. Journal of Economic Theory, 151:342-380, 2014.

Athanasios Geromichalos, Juan Manuel Licari, and Jose Suarez-Lledo. Monetary policy and asset prices. Review of Economic Dynamics, 10(4):761-779, 2007.

Milton Harris and Artur Raviv. Differences of opinion make a horse race. Review of Financial studies, 6(3):473-506, 1993.

J Michael Harrison and David M Kreps. Speculative investor behavior in a stock market with heterogeneous expectations. The Quarterly Journal of Economics, pages 323-336, 1978.

Harrison Hong and Jeremy C Stein. Differences of opinion, short-sales constraints, and market crashes. Review of financial studies, 16(2):487-525, 2003.

Nicolas L Jacquet and Serene Tan. Money and asset prices with uninsurable risks. Journal of Monetary Economics, 59(8): 784-797, 2012.

Oscar Jorda, Moritz Schularick, and Alan M Taylor. When credit bites back. Journal of Money, Credit and Banking, 45(s2):3-28, 2013.

Nobuhiro Kiyotaki and John Moore. 2002 Lawrence r. Klein lecture liquidity and asset prices*. International Economic Review, 46(2):317-349, 2005.

Nobuhiro Kiyotaki and Randall Wright. On money as a medium of exchange. The Journal of Political Economy, pages 927-954, 1989.

Narayana R Kocherlakota. Societal benefits of illiquid bonds. Journal of Economic Theory, 108(2):179-193, 2003.

Ricardo Lagos. Asset prices and liquidity in an exchange economy. Journal of Monetary Economics, 2010.

Ricardo Lagos. Moneyspots: extraneous attributes and the coexistence of money and interest-bearing nominal bonds. Journal of Political Economy, 121(1):127-185, 2013.

Ricardo Lagos and Randall Wright. A unified framework for monetary theory and policy analysis. Journal of Political Economy, 113(3):463-484, 2005.

Benjamin Lester, Andrew Postlewaite, and Randall Wright. Information, liquidity, asset prices, and monetary policy. The Review of Economic Studies, 79(3):1209-1238, 2012.

Robert E Lucas. Asset prices in an exchange economy. Econometrica: Journal of the Econometric Society, pages 1429-1445, 1978.

Rajnish Mehra and Edward C Prescott. The equity premium: A puzzle. Journal of Monetary Economics, 15(2):145-161, 1985.

Edward M Miller. Risk, uncertainty, and divergence of opinion. The Journal of Finance, 32(4):1151-1168, 1977.

Stephen Morris. Speculative investor behavior and learning. The Quarterly Journal of Economics, pages 1111-1133, 1996.

Ed Nosal and Guillaume Rocheteau. Money, payments, and liquidity. MIT press, 2011.

Guillaume Rocheteau. Payments and liquidity under adverse selection. Journal of Monetary Economics, 58(3):191-205, 2011.

Jose A Scheinkman and Wei Xiong. Overconfidence and speculative bubbles. Journal of political Economy, 111(6):1183-1220, 2003.

Shouyong Shi. Nominal bonds and interest rates*. International Economic Review, 46(2):579-612, 2005.

Shouyong Shi et al. Liquidity, interest rates and output. manuscript, University of Toronto, 2004.

Nancy Stokey and R Lucas. with e. Prescott (1989): Recursive methods in economic dynamics, 1989.

Hal R Varian. Divergence of opinion in complete markets: A note. The Journal of Finance, 40(1):309-317, 1985.

Neil Wallace, Barnett Banks, et al. The overlapping-generations model money. In Models Monetary Economies, 49-82. Federal Reserve Bank. Citeseer, 1980.

Tao Zhu and Neil Wallace. Pairwise trade and coexistence of money and higher-return assets. Journal of Economic Theory, 133(1):524-535, 2007.