Money is the medium used to transfer resources on the spot, while liquidity refers to the availability of a medium to transfer resources over time. The monetary search literature initiated by Kiyotaki and Wright (1989) has been successful in providing a solid micro foundation based on trade frictions for the emergence of money as a medium of exchange. On the other hand, a recent growing literature emphasizes the importance of financial frictions and liquidity constraints for the emergence of a medium to transfer resources over time. In particular, Kiyotaki and Moore (2001b) study the effect of limited supply of liquid assets on investment. Although, intuitively, money and liquidity would seem to be linked, these two approaches take them as separate issues.
The objective of the present paper is to explore a simple framework using a standard monetary search approach that allows us to study the issue of liquidity and its effect on investment. We are particularly interested in the relationship between money as a medium of spot trade and a medium of trade over time. Following Kiyotaki and Wright (1989), we assume that there exist frictions in spot trade. We introduce the notion of pledgeability and consider the possibility that the fundamental impediment arising in spot trade seeps into the credit market and hinders trade over time. In such an economy, agents may use money as a means of financing investment and money can perform two roles, as a provider of exchange and liquidity services.
Specifically, we consider a version of the divisible money model developed by Lagos and Wright (2005) which has a consumption and an investment market. Trading on the consumption market is subject to randomness and is not observable, hence money is used to lubricate the exchange of consumption goods. Trading on the investment market is instead frictionless. However, part of the investment returns accrue randomly to agents while they are trading on the opaque consumption market, and these returns cannot be pledged to outside investors to pay for investment costs. Thus, liquidity constraints may ensue. Within this setup, we show that when the average productivity of the returns is large enough to cover investment costs, the investment project is self-financing and money is used on the consumption but not on the investment market. Money is used as a medium of exchange but not as a provider of liquidity.
In this case, equilibrium displays a dichotomous nature: agents make an investment decision independently of liquidity concerns and the equilibrium investment is at the optimal level from purely productive point of view. Thus, inflation generates distortions only in terms of consumption. On the contrary, when the average productivity of the returns is relatively small, liquidity constraints arise in equilibrium and agents under-invest. In this case, agents use money both to relax the liquidity constraint and to finance consumption, thus inflation generates distortions both in terms of investment and consumption a relationship which turns out to be complementary. However, for sufficiently high inflation rates, money becomes relatively useless as a provider of liquidity services and agents stop using it to finance investment.
