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State prices, liquidity, and default

Espinoza, Raphael A., Goodhart, Charles and Tsomocos, Dimitrios P. (2009) State prices, liquidity, and default. Economic Theory, 39 (2). pp. 177-194. ISSN 0938-2259

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Identification Number: 10.1007/s00199-008-0343-y


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 shortterm 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 monetarycost risk premium.

Item Type: Article
Official URL:
Additional Information: © 2009 Springer
Divisions: Financial Markets Group
Subjects: H Social Sciences > HG Finance
Date Deposited: 07 Apr 2011 12:17
Last Modified: 20 Jun 2021 00:39

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