We develop a model where the coexistence of money and a higher yielding asset is endogenously obtained when no restriction is placed on the use of either object as a medium of exchange. Due to the presence of uninsurable risks, agents have, in equilibrium, di⁄erent relative valuations of the asset to money, and hence, the use of money as a means of payment is strictly preferred. This endogenous di⁄erence in the willingness of agents to use money over the asset implies that money carries a greater liquidity premium than the asset. We obtain that the asset strictly dominates money in terms of the expected rate of return, except at the Friedman rule. Since buyers are risk neutral with respect to the dividend payment of the asset, they hold both the asset and money despite the rate of return dominance of asset to money. We obtain that for low levels of ination the price of the asset, and therefore its real rate of return, is not a⁄ected by the rate of ination. This is because the asset is not used as a means of payment, only money is, and the price of the asset is given by its fundamental value. But when the ination rate becomes large enough, real balances are so low that buyers will then start using the asset as a means of payment in addition to money, and here, the asset will carry a liquidity premium as well, although it is smaller than that of money. The price of the asset is then increasing in the ination rate, and its real rate of return is therefore negatively correlated with the ination rate.
exchange economy, monetary policy, liquidity, inflation, markets, model
Finance | Public Economics
Journal of Monetary Economics
JACQUET, Nicolas L. and TAN, Serene.
Money and asset prices with uninsurable risks. (2012). Journal of Monetary Economics. 59, (8), 784-797. Research Collection School Of Economics.
Available at: http://ink.library.smu.edu.sg/soe_research/2001
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