, Volume 39, Issue 2, pp 177-194
Date: 29 Feb 2008

State prices, liquidity, and default

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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.

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.