A Monetary Approach to Asset Liquidity

This paper offers a monetary theory of asset liquidity—one that emphasizes the role of assets in payment arrangements—and it explores the implications of the theory for the relationship between assets’ intrinsic characteristics and liquidity, and the effects of monetary policy on asset prices and welfare. The environment is a random-matching economy where fiat money coexists with a real asset, and no restrictions are imposed on payment arrangements. The liquidity of the real asset is endogenized by introducing an informational asymmetry in regard to its fundamental value. The model delivers the following insights. A monetary equilibrium exists irrespective of the per capita supply of the real asset, provided that inflation is not too high. The illiquidity premium paid to the real asset tends to increase as the asset becomes riskier and more abundant. Monetary policy affects the real asset’s return when its quantity is not too large and inflation is in some intermediate range. The model predicts a negative relationship between inflation and the real asset’s expected return.