In this paper I develop an asset-pricing model in which financial assets are valued not only as claims to streams of consumption goods but also for their liquidity. By liquidity I mean the degree to which an asset is valued as a medium of exchange at the margin. Specifically, I study a class of exchange economies in which agents sometimes trade goods and financial assets as in Walrasian theory (in well-organized markets, at market-clearing prices), and sometimes as in search theory (in a decentralized manner, with the terms of trade determined by bargaining). Decentralized trade combined with an exchange motive generates the need for a medium of exchange. The equilibrium price and rate of return of a financial asset are partly determined by the asset’s usefulness to facilitate exchange. When an asset is held partly for its exchange value, the demand for the asset and its price tend to be higher than if the asset were not held for exchange. Its intrinsic rate of return–which takes into account only the stream of consumption goods that the asset represents–will be lower.
In Sections 2—4 I consider an economy with two assets: an equity share and a one-period government-issued risk-free real bill. In the basic setup, assets differ only in their payoffs, and agents are free to choose which assets to use as means of payment in decentralized trades. In this case, the theory unambiguously predicts that someone testing an agent’s Euler equation for the risk-free bill using its intrinsic rate of return would find that, at the margin, this agent can gain from transferring consumption from the future to the present. That is, there would appear to be a risk-free rate puzzle.
In Section 5 I analyze versions of the economy in which legal or institutional restrictions give bonds an advantage over equity as a medium of exchange. In this case, it is possible to show that there are degrees of these restrictions for which someone testing an agent’s Euler Equation for the intrinsic excess returns would find that, at the margin, the agent can gain from disinvesting in bills and investing in equity: There would appear to be an equity-premium puzzle. For this class of economies, the risk-free rate would still seem too low to an outside observer. In fact, the risk-free rate will be even lower than it would be in the absence of the legal or institutional restrictions. Without these restrictions, the theory may still be consistent with an equity premium puzzle, depending on parameter values. These results are discussed in Section 6.
In Section 7 I calibrate the model economies and study the extent to which they are able to generate average equity returns and risk-free rates that are in line with U.S. data. (For the empirical implementation, the model must be extended so that it is stationary in the growth rate of the aggregate endowment. This extension is worked out in the Appendix.) Since the class of model economies I consider nests the one studied by Mehra and Prescott (1985), I can quantify the degree to which the liquidity mechanism considered here can help explain the anomalies they identified. Mehra and Prescott’s test of their theory essentially consisted of experimenting with different values of the curvature of the agent’s utility function (call it ?) to find out for which values the average risk-free rate and equity premium in the model matched those in the U.S. economy. I carry out a similar exercise.
First, I consider the economy with no legal or institutional differences between equity shares and bills, and assess the ability of the model to produce risk-free rates and equity premia that match the data, for values of ? ranging from 1 to 10. I find that for values of ? up to 7, the liquidity mechanism is inactive, and the equilibrium looks just like the one in Mehra—Prescott. For values of ? equal to or greater than 8, equity shares and bills are valuable in decentralized exchange at the margin, which lowers the return on equity and the risk-free rate from what they would be in the Mehra—Prescott economy and brings them closer to the data. However, relative to the data, for this range of ? the equity return is a bit too low and the risk-free rate a bit too high, so the average equity premium is still too low.
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