Variation 2: Random liquidity needs

Abstract

The models presented so far have been silent on why money is commonly held by agents despite being dominated in return by other assets. Instead, the whole issue has been simply defined away by virtue of the untenable assumption that all assets have equal rates of return. To treat the issue of return-dominance in such a way is hardly satisfactory, and, therefore, we turn now to a version of the Diamond model due to Schreft/Smith (1997) in which assets are no longer uniquely characterized by their return rates. Instead, Schreft/Smith (1997) present a framework with an elaborate timing of events that stresses the liquidity aspects of assets. Due to different degrees of liquidity, interest-bearing assets and money cease to be perfect substitutes, and as in the previous chapter this changes the mechanics of the base model in a significant way. Moreover, Schreft/Smith (1997) assume that the government issues not only money, but also illiquid, interest-bearing bonds which compete with capital in the portfolios of agents. Thus, compared to the base model, Schreft/Smith (1997) present a framework with a rich financial structure, and this makes it more rewarding to analyze the interaction of monetary policy and financial markets. Otherwise things are arranged in a conventional manner: capital markets operate smoothly, and trades in all markets are settled according to some centralized, frictionless trading scheme in Walrasian manner.