Cash-in-the-Market Pricing in a Model with Money and Over-the-Counter Financial Markets

Entrepreneurs need cash to finance their investments. Since cash is costly to hold, entrepreneurs underinvest. If entrepreneurs are able to access secondary financial markets, then they can sell some of their less liquid assets for cash and invest at a higher level. When the secondary financial markets are over-the-counter (OTC), the amount of liquidity (cash) that is in the market affects asset prices. In particular, higher levels of liquidity lead to higher asset prices. Since the amount of cash in the market affects assets prices, asset prices can fluctuate over time even though asset fundamentals are unchanged. Bid and ask prices naturally arise in an OTC market. We find that the bid-ask spread is negatively correlated with asset returns– which is well documented in the literature– and positively correlated with inflation. Importantly, we also find that an increase in inflation increases returns and, hence, decreases asset prices.