State prices, liquidity, and default Raphaël A. Espinoza Charles. A. E. Goodhart Dimitrios P. Tsomocos Email author Research Article

First Online: 29 February 2008 Received: 15 October 2007 Accepted: 04 February 2008 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 constraints Default Asset prices Risk-neutral probabilities The authors are grateful for suggestions and comments on earlier versions of this paper from Valpy FitzGerald, John Geanakoplos, Pete Kyle, Herakles Polemarchakis, Oren Sussman, and from participants at the 2007 Meeting of the Society for the Advancement of Economic Theory (SAET), the 22nd Annual Congress of the European Economic Association, the Third Monetary Policy Research Workshop in Latin America and the Caribbean (Banco de la República de Colombia and Bank of England), and workshops at the Saïd Business School (Oxford) and at the Bank of England. The views expressed in this paper are those of the authors and do not represent those of the European Central Bank or the Eurosystem.

References Backus D., Gregory A. and Zin S. (1989). Risk premiums in the term structure: evidence from artificial economies.

J Monet Econ 24(3): 371–399

CrossRef Google Scholar Bansal R. and Coleman II W.J. (1996). A monetary explanation of the equity premium, term premium and risk-free rate puzzles.

J Polit Econ 104(6): 1135–1171

CrossRef Google Scholar Bloise G. (2006). A note on the existence of a monetary equilibrium over an infinite horizon.

Econ Theory 27(1): 59–77

CrossRef Google Scholar Bloise G., Drèze J. and Polemarchakis H. (2005). Monetary equilibria over an infinite horizon.

Econ Theory 25(1): 51–74

CrossRef Google Scholar Breeden D. (1979). An intertemporal asset pricing model with stochastic consumption and investment opportunities.

J Financ Econ 7: 265–296

CrossRef Google Scholar Breeden D. and Litzenberger R. (1978). Prices of state-contingent claims implicit in option prices.

J Bus 51(4): 621–651

CrossRef Google Scholar Clower B.W. (1967). A reconsideration of the microeconomic foundations of monetary theory.

Western Econ J 6: 1–8

Google Scholar Dubey P. and Geanakoplos J. (1992). The value of money in a finite-horizon economy: a role for banks. In: Dasgupta, P. and Gale, D. (eds) Economic Analysis of Market and Games, pp. M.I.T. Press, Cambridge

Google Scholar Dubey P. and Geanakoplos J. (2006). Determinacy with nominal assets and outside money.

Econ Theory 27(1): 79–106

CrossRef Google Scholar Fan M. (2006). Heterogeneous beliefs, the term structure and time-varying risk premia.

Ann Finance 2(3): 259–285

CrossRef Google Scholar Geanakoplos J. and Tsomocos D. (2002). International finance in general equilibrium.

Res Econ 56(1): 85–142

CrossRef Google Scholar Gurley J.G. and Shaw E.S. (1960). Money in a Theory of Finance. The Brookings Institution, Washington

Google Scholar Goodhart C.A.E., Sunirand P. and Tsomocos D. (2006). A model to analyse financial fragility.

Econ Theory 27(1): 107–142

CrossRef Google Scholar Hicks J.R. (1946). Value and Capital, 2nd edn. Oxford University Press, Oxford

Google Scholar Lucas R. (1978). Asset prices in an exchange economy.

Econometrica 46(6): 1429–1445

CrossRef Google Scholar Lucas R. (1990). Liquidity and interest rates.

J Econ Theory 50(2): 237–264

CrossRef Google Scholar Lucas R. and Stokey N. (1987). Money and interest in a cash-in-advance economy.

Econometrica 55(3): 491–514

CrossRef Google Scholar Lutz F.A. (1940). The structure of interest rates.

Q J Econ 55(1): 36–63

CrossRef Google Scholar Mehra R. and Prescott E. (1985). The equity premium: a puzzle.

J Monet Econ 15(2): 145–162

CrossRef Google Scholar Modigliani F. and Sutch R. (1967). Debt management and the term structure of interest rates: an analysis of recent experience.

J Polit Econ 75(4): 569–589

CrossRef Google Scholar Santos M.S. (2006). The value of money in a dynamic equilibrium model.

Econ Theory 27(1): 39–58

CrossRef Google Scholar Shiller R.J. (1990). The term structure of interest rates. In: Friedman, B.M. and Hahn, F.H. (eds) Handbook of Monetary Economics, vol. 1, pp. North Holland, Amsterdam

Google Scholar Shubik M. and Tsomocos D.P. (1992). A strategic market game with a mutual bank with fractional reserves and redemption in gold (A continuum of traders).

J Econ 55(2): 123–150

Google Scholar Shubik M. and Wilson C. (1977). The optimal bankruptcy rule in a trading economy using fiat money.

J Econ 37(3–4): 337–354

Google Scholar Tsomocos D. (2003). Equilibrium analysis, banking and financial instability.

J Math Econ 39(5-6): 619–655

CrossRef Google Scholar Tsomocos, D.: Generic determinacy and money non-neutrality of international monetary equilibria. J Math Econ (2008) forthcoming

Authors and Affiliations Raphaël A. Espinoza Charles. A. E. Goodhart Dimitrios P. Tsomocos Email author 1. University of Oxford Oxford UK 2. European Central Bank Frankfurt Germany 3. Christ Church Oxford UK 4. Financial Markets Group London School of Economics London UK 5. Saïd Business School and St. Edmund Hall University of Oxford Oxford UK