Equilibrium, efficient-markets, and liquidity in the cash-in-advance model
Arroyo, Cristino Rodriguez, III
Brown, Bryan W.
Doctor of Philosophy
The existence of equilibrium is a test of the internal consistency of an economic model. In any model with domestic moneys and dividend-yielding assets, the first question is: will money be dominated by assets in equilibrium? In cash-in-advance models domestic moneys always have positive liquidity value as instruments for domestic commodity transactions. If a non-dominated liquidity role for domestic currencies is posited existence of equilibrium is not usually problematic. For the case where information flows lead to binding cash-in-advance constraints an equilibrium exists in which domestic moneys have positive liquidity value. This equilibrium possesses the unit velocity property, but leads to a sharper characterization of equilibrium market and shadow prices in relation to fundamentals. That fiat money should be the unique provider of liquidity services is not necessary for equilibrium. It is possible to construct models with well-defined equilibria in which financial assets provide liquidity services. In these models the pricing equations for liquidity-providing assets contain premia for these services over and above risk premia and returns for delaying consumption. Such models can also generate new relationships between the velocity of money or the spot exchange rate and asset returns. That markets be information-efficient is, however, necessary for equilibrium. Consequently, any rejection of efficient-markets is evidence against the assumptions of the equilibrium theory. Consider, for instance, the case of the efficiency of forward exchange rates vis-a-vis spot rates. Depending on whether forward speculation is consummated through arbitrage of currencies or of assets (e.g., covered and uncovered bonds) the forward efficiency condition will or will not involve liquidity premia. In testing forward efficiency in both models we find, however, there is no material change in the results. Forward efficiency appears to be robust as well to specifications of the utility function. However there is evidence that forward efficiency is not robust to either the measurement of consumption risk, or the choice of covariance estimator of the forecast error.
Economic theory; Economics; Finance