What are the determinants of an asset liquidity? Kiyotaki and Wright (1989) provided an answer to this question twenty years ago, in the context of a monetary model with bilateral trades. They found that the moneyness of an asset depends on its physical properties (e.g., its storage cost, divisibility, or recognizability), fundamentals (such as the pattern of specialization), and conventions (i.e., self fulfilling beliefs). These insights, however, were derived under extreme portfolio restrictions agents cannot hold more than one unit of an asset land stark assumptions such as indivisible assets and goods. Recent developments in the search theoretic approach to monetary economies (e.g., Shi, 1997; Lagos and Wright, 2005) that allow for unrestricted portfolios and divisible assets have led to a renewed interest for the initial question that prompted this literature What makes money money?
Lester, Postlewaite, and Wright (2007) and Kim and Lee (2008) focus on the physical properties of assets and show that fiat money is a superior means of payment because it is harder to counterfeit and easier to authentify than other assets. Rocheteau (2007) uses the properties of the dividend process of an asset to explain its liquidity. In this paper, we pursue the view that trading arrangements are to a large extent the result of arbitrary conventions. Individuals prefer to trade with currency instead of bonds or equity because they coordinate on a trading mechanism that, despite beeing (pairwise) efficient, makes it less costly to trade the former than the latters. For instance, even if one could use bonds and shares as means of payment, currency might be preferred by buyers since it warrants better terms of trade.
To develop our argument, we adopt the search theoretic model of Lagos and Wright (2005), in which a lack of double coincidence of wants and the absence of a record$keeping technology in decentralized markets generate an explicit need for a medium of exchange. For our purpose, a crucial aspect of the model is that some trades take place in bilateral meetings. Because the Pareto frontier of the bargaining set (i.e., the pairwise core) in a bilateral match is non degenerate, the model is consistent with a large set of pairwise Pareto efficient allocations. We will exploit this feature of the model to select a mechanism that generates an outcome that is qualitatively consistent with the data. Besides money, we introduce real assets akin to "Lucas' trees" that yield a flow of real dividends. In accordance with the Wallace (1996) dictum, no restrictions are placed on the use of assets as means of payment.
While most of the recent search literature assumes an axiomatic bargaining solution to determine terms of trades in bilateral meetings, we follow Zhu and Wallace (2007) and only retain the axiom of Pareto efficiency. Agents behave rationally in the sense that they use as much assets as is needed not to leave some gains from trade unexploited. Obviously, additional properties of the bargaining solution are needed to get a unique outcome. Since no other axiom than Pareto efficiency is uncontroversial, we follow a different road and let some aspects of the data guide us. We want the trading mechanism to be able to generate rate of return differences between interest bearing assets and currency, or even between seemingly identical interest bearing assets. Such a property of the model would help explaining asset pricing anomalies, such the risk free rate and equity premium puzzles, or to account for a liquidity based structure of asset yields. We also want the model to generate the observed negative relationship between inflation and assets returns.
We choose a family of trading mechanisms that replicates the same asset pricing patterns as the ones in the economy with liquidity constraints of Kiyotaki and Moore (2005). The liquidity constraint in the Kiyotaky Moore model takes the form of a restriction on the fraction of their real asset hodings that agents can use to finance consumption opportunities. Such trading restrictions are able to generate the asset pricing anomalies and the effects of monetary policy we wish to explain. A key difference with the approach of Kiyotaki and Moore, however, is that there are no such liquidity constraints in our environment. The family of trading mechanisms we consider is parametrized by a single parameter just like the generalized Nash solution land it admits as particular cases the pricing mechanisms considered in Geromichalos, Licari and Suarez Lledo (2007), Lagos (2007), Lagos and Rocheteau (2008), Zhu and Wallace (2005).
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