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Monetary transaction costs and the term premium


We show that, in a monetary equilibrium, trade and asset prices depend on both the supply of liquidity by the central bank and the liquidity of assets and commodities. Because money demand is a function of the liquidity of assets and commodities, monetary aggregates provide information on trade inefficiencies and are thus instructive for the conduct of monetary policy. We also show that assets that promise higher payoffs in liquidity constrained states in the future are relatively more expensive. This generates a term premium in the yield curve, even in absence of aggregate real uncertainty. The term premium is also higher than what would be calibrated in a representative agent model because monetary costs affect individual agents’ marginal utilities even if aggregate income is unaffected. Our results hold in any monetary economy with heterogeneous agents and short-term liquidity effects, where monetary costs act as transaction costs and the quantity theory of money is verified.

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  1. The modern treatment of cash-in-advance models dates as far back as Clower (1967).

  2. The only exception is when interest rates are equal to zero. Then changing prices and money supply is tantamount to changing units of account while maintaining zero interest rates.

  3. See Dubey and Geanakoplos (2006) and Tsomocos (2008) for a formal proof.

  4. For this to be true, it is necessary for inflation to be costless. The Lucas Parable and Calvo-pricing are two ways to generate costly distortion of relative prices because of inflation, but this case is outside the scope of the paper.

  5. Subjective probabilities can be adjusted to take into account the subjective discount rate.

  6. Of course these two sets are only defined in equilibria—the same applies to the sets \(L_s^{i}(\pm )\)—and it is, therefore, a notation abuse to write the maximization problem as if the sets were known ex ante.

  7. The existence of a Monetary Equilibrium is ensured when the Gains-from-Trade Hypothesis (Dubey and Geanakoplos 1992, 2003) is satisfied.

  8. The demand and supply for commodities and assets depend on all the prices and the other exogenous parameters. For the sake of exposition, we only write the dependence on the respective price of goods or assets.

  9. Interior solutions are guaranteed by the preference and endowment specification we have adopted.

  10. Equilibria such that prices increase with liquidity exist, as it is demonstrated in Espinoza et al. (2009).

  11. The Quantity Theory of Money becomes \((1-\varLambda _{s,l_0}+(1+\varLambda _{s,l_0}r_s)(1-\lambda _s)/(1+r_s)) p_{s,l_0}q_{s,l_0}=M_s+\lambda _s m_s^{\alpha }+m_s^{\beta }\) in a one commodity economy


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Correspondence to Raphael Espinoza.

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We are grateful for suggestions and helpful comments from Sudipto Bhattacharya, Valpy FitzGerald, John Geanakoplos, Charles Goodhart, Pete Kyle, Herakles Polemarchakis, Tano Santos, Oren Sussman, and from participants at the Annual CARESS-Cowles Conference, the European Winter Econometric Society Meeting, the Royal Economic Society Meeting, the European Workshop on General Equilibrium, the INFINITI Conference, the EEA Congress, and seminars at Oxford and the Bank of England. However, all remaining errors are ours. The views expressed in this paper are those of the authors solely and do not represent the views of the IMF or IMF policy.

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Espinoza, R., Tsomocos, D. Monetary transaction costs and the term premium. Econ Theory 59, 355–375 (2015).

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  • Liquidity
  • Cash-in-advance constraints
  • Monetary aggregates
  • Term structure of interest rates

JEL Classification

  • E43
  • G12