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.