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Money, Asset Prices and the Liquidity Premium

Lee, Seungduck (2016): Money, Asset Prices and the Liquidity Premium.

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Abstract

This paper examines the effect of monetary policy on the liquidity premium, i.e., the market value of the liquidity services that financial assets provide. To guide the empirical analysis, I set up a monetary search model in which bonds provide liquidity services in addition to money. The theory predicts that money supply and nominal interest rates are positively correlated with the liquidity premium, but the premium is negatively correlated with the bond supply. The empirical analysis over the period from 1946 and 2008 confirms the theoretical predictions. This indicates that liquid bonds are substantive substitutes for money and the opportunity cost of holding money plays a key role in asset price determination. Lastly, the theory rationalizes the existence of negative nominal yields in equilibrium, when the cost of holding money is low whereas liquid bonds are scarce, and I present empirical findings to support it.

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