Liquidity, interest rates and output

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Abstract

This paper integrates monetary search theory with limited participation to analyze the liquidity effect of open market operations. The model features a centralized bonds market with limited participation and a decentralized goods market with random matches. In a fraction of matches, buyers can use un- matured bonds together with money to purchase goods. In other matches, a legal restriction forbids the use of bonds as the means of payments. In this economy, a shock to bond sales has two distinct liquidity effects. One is the immediate liquidity effect on the bond price and the nominal interest rate. The other is a liquidity effect in the goods market starting one period later, which arises as unmatured bonds facilitate trades. Thus, even independent shocks in the open market can have persistent effects on interest rates and real output. I establish the existence of the equilibrium and, with numerical examples, examine equilibrium properties.

Original languageEnglish (US)
Pages (from-to)53-95
Number of pages43
JournalAnnals of Economics and Finance
Volume15
Issue number1
StatePublished - Jan 1 2014

All Science Journal Classification (ASJC) codes

  • Finance
  • Economics and Econometrics

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