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FEDERAL RESERVE BANK OF CLEVELAND

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POLICY DISCUSSION PAPER

By Joseph G. Haubrich, Guillaume Rocheteau, Pierre-Olivier Weill, and
Randall Wright

NUMBER 26

May

A Conference on Liquidity in
Frictional Markets

2009

POLICY DISCUSSION PAPERS

FEDERAL RESERVE BANK OF CLEVELAND

A Conference on Liquidity in
Frictional Markets
By Joseph G. Haubrich, Guillaume Rocheteau, Pierre-Olivier Weill, and Randall Wright

This Policy Discussion Paper summarizes the papers that were presented at the
Liquidity in Frictional Markets conference in November 2008. The papers, which looked
at markets for assets as diverse as houses, bank loans, and electronic funds transfer, all
explored that amorphous concept called “liquidity” and how its presence—or absence—
affects the economy.

Joseph G. Haubrich is
vice president at the
Federal Reserve Bank
of Cleveland. Guillaume
Rocheteau is associate
professor of economics
at the University of
California at Irvine.
Pierre-Olivier Weill is
assistant professor
of economics at the
University of California,
Los Angeles. Randall
Wright is the James Kim
Professor of Economics
at the University of
Pennsylvania.
Materials may be
reprinted, provided that
the source is credited.
Please send copies of
reprinted materials to the
editor.

POLICY DISCUSSION PAPERS

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ISSN 1528-4344

FEDERAL RESERVE BANK OF CLEVELAND

Introduction
On November 14-15, 2008, a group of distinguished scholars met in the conference room of the
Federal Reserve Bank of Cleveland’s Learning Center and Money Museum to discuss issues relating to “Liquidity in Frictional Markets.” The conference was cosponsored by the Journal of Money, Credit, and Banking. The papers, which looked at markets for assets as diverse as houses, bank
loans, and electronic funds transfer, all explored that amorphous concept called “liquidity” and
how its presence—or absence—affects the economy. The papers also shared a methodological perspective, using search, network, and game theories as alternatives to Walrasian market clearing.

Monetary Policy
Three papers focused on monetary policy.
In “Elastic Money, Inflation, and Interest Rate Policy,” Allen Head and Junfeng Qiu study
optimal monetary policy in an environment in which money plays a basic role in facilitating

Elastic Money, Inflation,
and Interest Rate Policy

exchange, while aggregate shocks affect households asymmetrically and exchange may be con-

Allen Head and Junfeng Qiu

ducted using either bank deposits (inside money) or fiat currency (outside money). A central
bank controls the stock of outside money in the long run and responds to shocks in the short run
using an interest rate policy that manages private banks’ creation of inside money and influences
households’ consumption. The zero bound on nominal interest rates prevents the central bank
from achieving efficiency in all states. Long-run inflation can improve welfare by mitigating the
effect of this bound.
In “Price-Level Targeting and Stabilization Policy” Aleksander Berentsen and Christopher
Waller construct a dynamic stochastic general equilibrium model to study optimal monetary stabilization policy. Prices are fully flexible, and money is essential for trade. Their main result is that
if the central bank pursues a price-level target, it can control inflation expectations and improve

Price-Level Targeting
and Stabilization Policy
Aleksander Berentsen and
Christopher Waller

welfare by stabilizing short-run shocks to the economy. The optimal policy involves smoothing
nominal interest rates, which effectively smoothes consumption across states.
Nicolas L. Jacquet and Serene Tan, in “Money, Bargaining, and Risk Sharing,” investigate
money’s dual role as a self-insurance device and a means of payment, when perfect risk-sharing
is not possible and the two roles of money are disentangled. They use a variant of Lagos and
Wright’s approach (2005), where agents face a risk in the centralized market as follows. In the

Money, Bargaining, and
Risk Sharing
Nicolas L. Jacquet and
Serene Tan

decentralized market, the main role for money is as a means of payment, while in the centralized
market it is a self-insurance device. The authors show that state-contingent inflation rates can improve agents’ ability to self-insure in the centralized market, thereby improving the terms of trade
in the decentralized market. The authors also characterize the optimal monetary policy.

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POLICY DISCUSSION PAPERS

NUMBER 26, MAY 2009

Payments Systems
Four papers focused on the payments system and the nuts and bolts of the monetary system.
In “Counterfeiting as Private Money in Mechanism Design,” Ricardo Cavalcanti and Ed
Nosal describe counterfeiting activity as the issuance of private money, one which is difficult to
monitor. The approach, which amends the basic random-matching model of money in mechanism design, allows a tractable welfare analysis of currency competition. They show that it is not
efficient to eliminate counterfeiting activity completely. They do this without appealing to lottery

Counterfeiting as
Private Money in
Mechanism Design
Ricardo Cavalcanti and
Ed Nosal

devices, and argue that this is consistent with imperfect monitoring.
Adam Ashcraft, James McAndrews, and David Skeie consider “Precautionary Reserves and
the Interbank Market.” Liquidity hoarding by banks and extreme volatility of the federal funds
rate was widely seen as having severely disrupted the interbank market and the broader financial
system during the 2007–08 financial crisis. Using a dataset of intraday Federal Reserve bank
account balances and Fedwire interbank transactions, the authors estimate all overnight federal

Precautionary Reserves
and the Interbank
Market
Adam Ashcraft,
James McAndrews, and
David Skeie

funds trades during this time period. They document the extreme federal funds rate volatility that
occurred and provide empirical evidence on banks’ precautionary hoarding of reserves and reluctance to lend. The authors then develop a model with credit and liquidity frictions in the interbank market consistent with the empirical results. Banks rationally hold excess reserves intraday
and overnight as a precautionary measure to self-insure against liquidity shocks. The intraday fed
funds rate sometimes spikes above the discount rate and falls near zero. Apparent anomalies during the crisis may be explained as the stark but natural outcomes of the authors’ general model of
the interbank market. The model also provides a unified explanation for previously documented
stylized facts and makes new predictions for the interbank market.
In “Systemic Risk and Liquidity in Payment Systems,” Gara M. Afonso and Hyun Song Shin
study liquidity and systemic risk in high-value payment systems. Flows in such high-value systems are characterized by high velocity, meaning that the total amount paid and received is high
relative to the stock of reserves. In such systems, banks rely heavily on incoming funds to finance
outgoing payments, necessitating a high degree of coordination and synchronization. They use

Systemic Risk and
Liquidity in Payment
Systems
Gara M. Afonso and
Hyun Song Shin

lattice-theoretic methods to solve for the unique fixed point of an equilibrium mapping and conduct comparative statics analyses on changes to the environment. Banks that attempt to conserve
liquidity actually increase the demand for intraday credit and, ultimately, cause a disruption of
payments. Additionally, when a bank is identified as vulnerable to failure and other banks cancel
payments to that bank, there are systemic repercussions.
Ricardo Lagos formulates a search-based asset-pricing model in which both equity shares and
fiat money can be used as means of payment in “Asset Prices, Liquidity, and Monetary Policy in
an Exchange Economy.” It is then possible for him to characterize a family of optimal stochastic
monetary policies. Every policy in this family implements Friedman’s prescription of zero nominal interest rates. Under an optimal policy, equity prices and returns are independent of monetary
considerations. The paper also studies a perturbation of the family of optimal policies that targets
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Asset Prices, Liquidity,
and Monetary Policy in
an Exchange Economy
Ricardo Lagos

FEDERAL RESERVE BANK OF CLEVELAND

a constant but nonzero nominal interest rate. Under such policies, the average real return on
equity is negatively correlated with the average inflation rate.

Trading Frictions in Asset Markets
Four papers looked at trading frictions in asset markets, continuing an influential recent trend to
use search models to examine market microstructure.
Like Lagos, Yong Kim, in “Liquidity and Selection in Asset Markets with Search Frictions,”
also looks at an asset market subject to search frictions, but one in which both asset liquidity and
market composition are determined endogenously. The analysis predicts that higher asset prices
resulting from exogenously higher asset earnings imply a:
•

Shorter owner tenure before listing assets for resale (turnover)

•

Higher stock of buyers

•

Yong Kim

Shorter search duration for sellers (higher liquidity)

•

Liquidity and Selection
in Asset Markets with
Search Frictions

Higher share of the asset stock traded (trade volume)

Asset price-earnings ratios respond positively to earnings because liquidity premiums respond
to the size of earnings relative to the costs of search. Kim shows that liquidity effects and selection
effects reinforce each other in the presence of search frictions.
In “Liquidity Provision in Capacity-Constrained Markets” Pierre-Olivier Weill studies a competitive, dynamic financial market subject to a transient selling pressure, when market makers
face a capacity constraint on the number of trades they can make with outside investors. This
induces market makers to provide liquidity in order to manage their capacity constraint optimally

Liquidity Provision in
Capacity-Constrained
Markets
Pierre-Olivier Weill

over time: They use slack capacity early to accumulate assets when the selling pressure is strong,
so as to relax their capacity constraint and sell to buyers more quickly when the selling pressure
subsides. When the capacity constraint binds, the bid-ask spread is strictly positive, widening and
narrowing as market makers build up and unwind their inventories. Since the equilibrium asset
allocation is constrained Pareto optimal, the time variations in bid-ask spreads are not symptomatic of inefficient liquidity provision.
In “Trading Frictions and House Price Dynamics,” Andrew Caplin and John Leahy construct
a model capable of explaining much of the recent experience in the housing market. Their model
of trade with matching frictions provides a simple characterization for the process through which

Trading Frictions and
House Price Dynamics
Andrew Caplin and John Leahy

sales and inventory determine housing prices. They then compare the implications of the model
to certain properties of housing markets and find it can explain the large price changes and the
positive correlation between house prices and sales found in the data. Unlike the data, prices are
negatively autocorrelated, and high inventory predicts price appreciation. They also investigate

When Banks Lend for
Too Long

several amendments to the model.
Christophe Chamley and Celine Rochon, in “When Banks Lend for too Long,” explore a

Christophe Chamley and
Celine Rochon

model of lending in which the decision between rolling over or terminating a loan is the result of
a privately efficient debt contract under imperfect information. Loans are established in matches

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POLICY DISCUSSION PAPERS

NUMBER 26, MAY 2009

between banks (lenders) and entrepreneurs (borrowers), who meet in a search process. Projects
randomly turn out a quick payout or a long-term payout that requires a rollover of the loan. The
model generates, under proper parameter conditions, multiple steady states, and a small monitoring cost may generate a large macroeconomic effect. The model is simplified for the analysis of the
dynamics. There is a continuum of cycles that are separated by crises, in which the stock of loans
is reduced by a quantum amount of loan terminations.

Money, Liquidity, and Banks
Three papers explored the subtle relationships between money, liquidity, and banks.
“Information, Liquidity, and Asset Prices” by Benjamin Lester, Andrew Postlewaite, and Randall Wright studies how recognizability affects assets’ acceptability, or liquidity. Some assets, like
U.S. currency, are readily accepted because sellers can easily recognize their value, unlike stock
certificates, bonds, or foreign currency. This idea is common in monetary economics, but previous models deliver equilibria where less-recognizable assets are always accepted with positive

Information, Liquidity,
and Asset Prices
Benjamin Lester,
Andrew Postlewaite, and
Randall Wright

probability, never zero probability. This is inconvenient when prices are determined through
bargaining, which is difficult with private information. These authors construct models in which
agents outright reject assets that they cannot recognize, at least for some parameters. Thus, information frictions generate liquidity differences without overly complicating the analysis.
In “Uncertainty, Inflation, and Welfare,” Jonathan Chiu and Miguel Molico use a microfounded search-theoretic monetary model to study the welfare costs and redistributive effects
of inflation when there is idiosyncratic liquidity risk. They calibrate the model to match the
empirical aggregate money demand and the distribution of money holdings across households,

Uncertainty, Inflation,
and Welfare
Jonathan Chiu and
Miguel Molico

and study the effects of inflation under the implied degree of market incompleteness. In the
presence of imperfect insurance, the estimated long-run welfare costs of inflation are on average
40 percent smaller than in a complete-markets, representative-agent economy. Furthermore, inflation induces important redistributive effects across households. For example, the welfare gains
of reducing inflation from 10 percent to 0 percent is 0.59 percent of income. Moreover, the
marginal redistributive effect of inflation is decreasing in the rate of inflation. They conclude that
accounting for wealth effects is important for the measurement of the welfare costs of inflation,
given that these effects are quantitatively significant.
Valerie R. Bencivenga and Gabriele Camera, in “Banks, Liquidity Insurance, and Interest
on Reserves in a Matching Model of Money,” introduce banks resembling those in Diamond
and Dybvig (1983) into a model of money and capital based on Lagos and Wright (2005) and
Aruoba and Wright (2003). Agents can self-insure against random liquidity needs by carrying
money balances, but they can also withdraw money from their bank deposits, although there is a
real resource cost of doing so. Banks create liquidity by pooling agents’ savings and by holding a
portfolio of primary assets (money and capital) that maximizes depositors’ expected utility. From
an agent’s perspective, banks provide liquidity insurance; they reduce or eliminate unused money
balances. In the aggregate, banks shift the composition of savings toward investment in physical
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Banks, Liquidity
Insurance, and
Interest on Reserves
in a Matching Model of
Money
Valerie R. Bencivenga and
Gabriele Camera

FEDERAL RESERVE BANK OF CLEVELAND

capital, which increases agents’ rate of return on their savings. Thus, banks have the potential to
improve welfare, despite their cost. When the withdrawal cost is sufficiently small, agents save
only through deposits, and banks provide complete liquidity insurance (there are no unused
money balances). When the cost is moderate, agents optimally combine self-insurance (agents
carry some money) and liquidity insurance through banks (some agents make withdrawals, and
banks hold reserves). The optimal contract has a nonlinear schedule of interest rates on deposits in
this case. When the cost is large, liquidity insurance becomes prohibitively expensive, and banks
cannot improve welfare. The threshold levels of the cost are increasing in the inflation rate. A
policy of paying interest on reserves can reverse some or all of the distortionary effects of inflation,
provided the withdrawal cost is sufficiently small, by inducing banks to offer specific incentivecompatible deposit contracts. Banks cannot observe agents’ liquidity needs, and therefore deposit
contracts cannot condition on them.
The conference covered a broad range of papers in terms of techniques used, questions addressed, and markets investigated. Perhaps the broad message of these papers is that a deeper
understanding of market mechanisms and the frictions that lead to them can yield insights that
are surprisingly relevant for policy questions.

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NUMBER 26, MAY 2009

References
Diamond, Douglas W., and Philip Dybvig. 1983. “Bank Runs, Deposit Insurance, and
Liquidity,” Journal of Political Economy, vol. 91 pp. 401–19.
Aruoba, S. Boragan, and Randall W. Wright. 2003. “Search, Money, and Capital:
A Neoclassical Dichotomy,” Journal of Money Credit and Banking, 35(6), 1086–105.
Lagos, Ricardo, and Randall W. Wright, 2003. “A Unified Framework for Monetary Theory and
Policy Analysis,” Journal of Political Economy, vol. 113, pp. 463–84.

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FEDERAL RESERVE BANK OF CLEVELAND

Papers Presented at the Conference
Asset Prices, Liquidity, and Monetary Policy in an Exchange Economy
Ricardo Lagos
Banks, Liquidity Insurance, and Interest on Reserves in a Matching Model of Money
Valerie Bencivenga and Gabriele Camera
Counterfeiting as Private Money in Mechanism Design
Ricardo Cavalcanti and Ed Nosal
Federal Reserve Bank of Cleveland working paper, no. 07-16.
Elastic Money, Inflation, and Interest Rate Policy
Allen Head and Junfeng Qiu
Queen’s University working paper, no. 1152.
Information, Liquidity and Asset Prices
Benjamin Lester, Andrew Postlewaite, and Randall Wright
University of Pennsylvania, Penn Institute for Economic Research
working paper, no. 08-039.
Liquidity and Selection in Asset Markets with Search Friction
Yong Kim
Liquidity Provision in Capacity Constrained Markets
Pierre-Olivier Weill
Money, Bargaining, and Risk Sharing
Nicolas Jacquet and Serene Tan
Precautionary Reserves and the Interbank Market
Adam Ashcraft, James McAndrews, and David Skeie
Price-Level Targeting and Stabilization Policy
Aleksander Berentsen and Christopher Waller
Systemic Risk and Liquidity in Payment Systems
Gara Minguez Afonso and Hyun Song Shin
Federal Reserve Bank of New York staff report, no. 352.
Trading Frictions and House Price Dynamics
Caplin, Andrew, and John Leahy
National Bureau of Economic Research working paper, no. 14605.
Uncertainty, Inflation, and Welfare
Jonathan Chiu and Miguel Molico
Bank of Canada working paper, no 3002-13.
When Banks Lend for Too Long
Christophe Chamley and Celine Rochon

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