Ebook Liquidity, Business Cycles, and Monetary Policy
In this paper, we provide a model of monetary economy with differences in liquidity across assets. Our purpose is to understand how aggregate production and asset prices fluctuate with recurrent shocks to productivity and liquidity. In so doing, we want to find out what role government policy might have through open market operations that change the mix of assets held by the private sector. The present paper takes fiat money to be one of the assets under consideration. We investigate under what circumstances money is essential to a better allocation of resources. We show that certain apparent anomalies of the non monetary economy are in fact normal features of an economy where money is essential. Among the well known puzzles we have in mind are: the low risk free rate puzzle; the excess volatility of asset prices; the anomalous savings behaviour of certain households, and their low participation in asset markets. Before describing our monetary economy, we should start with some remarks about modeling strategy.
In broad terms, there are two ways of getting fiat money into a competitive macroeconomic model. One approach is to endow money with some special function for example, cash in advance or sticky nominal prices. The other approach is to starve agents of alternatives to money pas in an overlapping generations framework where money is the sole means of saving. Although the first approach, in particular the cash in advance model and the dynamic sticky price model, has proved important to monetary economics and policy analysis, it is not well suited to answering larger questions to do with liquidity. By endowing money with a special function in the otherwise frictionless economy with complete Arrow Debreu security market, one is imposing rather than explaining the use of money, which precludes the possibility that other assets or media of denomination may substitute for money. And the second approach rules out any general discussion of liquidity if there are no alternative assets to money.
There are many noncompetitive models of money, leading with the random matching framework. In principle, such models are suited to analyzing liquidity. But they are necessarily special, and it is difficult to incorporate them into the rest of macroeconomics. We believe there is a need for a work horse model of money and liquidity, with competitive markets, which does not stray too far from the other workhorse, the real business cycle model.
In our framework, markets are competitive, money is not endowed with any special function, and there are other assets traded besides money. The basic model presented in Section 2 has two kinds of agents, entrepreneurs and workers, homogeneous general output, and three assets: fiat money, physical capital (or equity of physical capital), and human capital. The supply of fiat money is fixed. The supply of capital changes through investment and depreciation. A workers human capital is inalienable, which means that he or she cannot borrow against future labour income: in any period, the only labour market is a spot market for that periods labour services. There is a commonly available technology for combining labour with capital to produce general output.
In each period a fraction of the entrepreneurs (but none of the workers) can invest in producing new capital from general output. The arrival of such an investment opportunity is randomly distributed across entrepreneurs through time. Because not all entrepreneurs can invest in each period, there is a need to transfer resources from those who do not have an investment opportunity (that periods savers) to those who do (that periods investors). To acquire general output as input for the production of new capital, investing entrepreneurs sell equity claims to the future returns from the newly produced capital. The crucial feature of the model is that, because the investing entrepreneur is still needed to run the project to produce output and he cannot precommit to work throughout its life, he is able to pledge only a fraction (say) of future returns from the new capital. As the investing entrepreneur can only issue new equity up to fraction of his investment, he faces a borrowing constraint.
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