Monetary Policy and Efficiency in Over-the-Counter Financial Trade

Athanasios, Geromichalos and Kuk Mo, Jung (2016): Monetary Policy and Efficiency in Over-the-Counter Financial Trade.

Abstract

We develop a monetary model that incorporates Over-the-Counter (OTC) asset trade. After agents have made their money holding decisions, they receive an idiosyncratic shock that affects their valuation for consumption and, hence, for the unique liquid asset, namely, money. Subsequently, agents can choose whether they want to enter the OTC market in order to sell assets and, thus, boost their liquidity, or to buy assets and, thus, provide liquidity to other agents. A unique feature of our model is that inflation affects welfare not only through the traditional channel, i.e., through determining equilibrium real balances, but also through influencing agents' entry decisions in the financial market. We use our framework to study the effect of inflation on welfare, asset prices, and OTC trade volume. In contrast to most monetary models, which predict a negative relationship between inflation and welfare, we find that inflation can be welfare improving within a certain range, because it mitigates a search externality that agents impose on one another when they make their OTC market entry decision.

• Item Type: MPRA Paper
• Language: English
• Keywords: monetary-search models, liquidity, asset prices, over-the-counter markets
• Subjects: E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level ; Inflation ; Deflation; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E50 - General; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates

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