Money and Asset Liquidity in Frictional Capital Markets

We endogenize asset liquidity and financing constraints in a dynamic general equilibrium model with search frictions on capital markets. Assets traded on frictional capital markets are only partially saleable. Liquid assets, such as fiat money, instead, are not subject to search frictions and can be used to insure idiosyncratic investment risks. Partially saleable assets thus carry a liquidity premium over fully liquid assets. We show that, in equilibrium, low asset saleability is typically associated with lower asset prices, tighter financing constraints, thus stronger demand for public liquidity. Lower asset liquidity feeds into real allocations, constraining real investment, consumption, and production.