Asset Prices in a Continuous-Time Liquidity Model of Monetary Economies

This paper develops a general equilibrium asset pricing model for monetary economies. The model extends the standard liquidity model first developed by Lucas (1990) and Fuerst (1992). The one-transaction-per-period assumption of their model is replaced with one that allows for multiple transactions in each period. This extension not only makes the liquidity model more realistic, but also provides a framework for testing it with data of much higher frequency than the original model would allow. As a general equilibrium asset pricing model for monetary economies, it improves upon the existing models in that the existing models, such as Lucas (1984), LeRoy (1984), Danthine and Donaldson (1986), Marshall (1992), Bakshi and Chen (1996,1997), and Basak and Gallmeyer (1997) can only capture the expected inflation effect of a monetary intervention, whereas this model can capture both the expected inflation and liquidity effects of the intervention. A closed-form solution is derived for a special case of the model to illustrate the effect of monetary expansion. The solution can be used, for example, for an in-depth study of the term structure of interest rates in the spirit of Cox, Ingersoll and Ross (1985b). It can also be used as a framework for empirically testing the liquidity effect of monetary policies on long term bonds. ∗Tan Wang is with Faculty of Commerce and Business Administration, University of British Columbia, 2053 Main Mall, Vancouver, B.C. V6T 1Z2, Canada; Email:[email protected]. Earlier versions of this paper have been presented at the 1998 Western Finance Association Meetings in Monterey, and the 1999 American Economic Association Meetings in New York. The author thanks Burton Hollifield his discussion, Suleyman Basak for his detailed comments. The support of the Social Sciences and Humanities Research Council of Canada is gratefully acknowledged.