Liquidity is an important concept in finance and macroeconomics. The microeconomic literature in finance views liquidity roughly as the ability to sell assets quickly and costlessly. In macroeconomics, liquidity refers to a generally accepted medium of exchange or, in brief, money. Money is the most liquid asset due to the fact that it does not need to be converted into anything else in order to make purchases of real goods or other assets. This feature makes money valuable in both perspectives.
This paper uses this common perspective of money and links liquidity risk on an asset market with aggregate demand and aggregate supply on a goods market. Spillover effects from the asset market to the goods market can justify a central bank intervention on the asset market even if the central bank does not take the welfare of investors on the asset market into account. Hence, the model provides a framework to analyse the perceived insurance against severe financial turmoil by the Federal Reserve under Alan Greenspan, which has been termed the ‘Greenspan put’ in the popular press and ‘liquidity provision principle’ by Taylor (2005).
Liquidity provision has been studied in the literature with a focus on the role of financial intermediaries (see, e.g., Allen and Gale, 1998; Diamond and Dybvig, 1983; Diamond and Rajan, 2001, 2005; Goodhart and Illing, 2002). Considerably less research looked at liquidity provision by financial markets (see, e.g., Allen and Gale, 1994; Holmström and Tirole, 1998). Furthermore, all of these papers use models with real assets and claims. If the aim is to analyse optimal monetary interventions on financial markets, however, it seems to be natural that one has to use a model in nominal units, since the central bank can provide nominal fiat money but not real goods. Only recently, Gale (2005) and Diamond and Rajan (2006) have made first steps in that direction and developed models with nominal assets. Contributing to this literature, I develop an analytical framework based on the cash-in-the-market pricing model of Allen and Gale (1994, 2005) that directly links monetary policy and liquidity on financial markets.
Before I turn to the details of the model, the following two sections provide empirical and historical evidence of the role of liquidity on asset prices and in financial crises.
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Liquidity Risk and Monetary Policy
