Economic Theory

, Volume 39, Issue 2, pp 177–194

State prices, liquidity, and default

Authors

  • Raphaël A. Espinoza
    • University of Oxford
    • European Central Bank
    • Christ Church
  • Charles. A. E. Goodhart
    • Financial Markets GroupLondon School of Economics
    • Saïd Business School and St. Edmund HallUniversity of Oxford
Research Article

DOI: 10.1007/s00199-008-0343-y

Cite this article as:
Espinoza, R.A., Goodhart, C.A.E. & Tsomocos, D.P. Econ Theory (2009) 39: 177. doi:10.1007/s00199-008-0343-y

Abstract

We show, in a monetary exchange economy, that asset prices in a complete markets general equilibrium are a function of the supply of liquidity by the Central Bank, through its effect on default and interest rates. Two agents trade goods and nominal assets to smooth consumption across periods and future states, in the presence of cash-in-advance financing costs that have effects on real allocations. We show that higher spot interest rates reduce trade and as a result increase state prices. Hence, states of nature with higher interest rates are also states of nature with higher risk-neutral probabilities. This result, which cannot be found in a Lucas-type representative agent model, implies that the yield curve is upward sloping in equilibrium, even when short-term interest rates are fairly stable and the variance of the (macroeconomic) stochastic discount factor is 0. The risk-premium in the term structure is, therefore, a monetary-cost risk premium.

Keywords

Cash-in-advance constraintsDefaultAsset pricesRisk-neutral probabilities

JEL Classification

E43G12

Copyright information

© Springer-Verlag 2008