In modern economies, transactions occur in two layers. In the end user layer, households, firms and institutional investors pay for goods and securities with inside money (payment instruments supplied by banks). In the bank layer, end users' payment instructions to banks generate interbank transactions, which are often made with reserves - outside money - via central banks' real time gross settlement systems, but may also be handled through short-term credit including interbank netting arrangements. Models of monetary policy are typically based on these institutional features.
We model the determination of asset prices and inflation in an economy with a layered payment system that supports trade in both goods and securities. In both the bank and end user layers, money is valued for its liquidity services, but its creation requires costly leverage. What happens in securities markets then matters for both the supply and the demand of inside money: securities are held by banks to back inside money, which is in turn used by other investors to pay for securities. As a result, asset prices, inflation and policy transmission depend on the institutional details of the payment system.
We see that when investors are unwilling to hold the economy' risk, equilibrium in asset markets is typically restored through a reduction in interest rates. If interest rates are constrained from below (the zero lower bound), a decrease in risk appetite instead ushers in asset price declines that drag down aggregate demand, which further drags down asset prices. Output and risk-gaps emerge simultaneously and are mutually reinforcing. These mechanisms seem to have played out forcefully in the past, particularly during the Great Financial Crisis. Yet mainstream macroeconomic models focus exclusively on the output gap component, while the risk-gap component plays only a secondary or no role.
This paper studies a modern monetary economy: trade in both goods and securities relies on money provided by intermediaries. While money is valued for its liquidity, its creation requires costly leverage. In ation, security prices and the transmission of monetary policy then depend on the institutional details of the payment system. The price of a security is higher if it helps back inside money, and lower if more inside money is used to trade it. In ation can be low in security market busts if bank portfolios suffer, but also in booms if trading absorbs more money. The government has multiple policy tools: in addition to the return on outside money, it affects the mix of securities used to back inside money.
JEL classification: E00, E13, E41, E42, E43, E44, E51, E52, E58, G1, G12, G21
Keywords: payments, monetary policy, liquidity trap, liquidity, asset prices, collateral premium, leverage, leverage costs, convenience yield, banking, scarce reserves, abundant reserves
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