Search Frictions and Asset Price Volatility

By B. Ravikumar and Enchuan Shao

http://d.repec.org/n?u=RePEc:bca:bocawp:10-1&r=dge

We examine the quantitative effect of search frictions in product markets on asset price volatility. We combine several features from Shi (1997) and Lagos and Wright (2005) in a model without money. Households prefer special goods and general goods. Special goods can be obtained only via a search in decentralized markets. General goods can be obtained via trade in centralized competitive markets and via ownership of an asset. There is only one asset in our model that yields general goods. The asset is also used as a medium of exchange in the decentralized market to obtain the special goods. The value of the asset in facilitating transactions in the decentralized market is determined endogenously. This transaction role makes the asset pricing implications of our model different from those in the standard asset pricing model. Our model not only delivers the observed average rate of return on equity and the volatility of the equity price, but also accounts for most of the spectral characteristics of the equity price.

The Shi (1997) and the Lagos and Wright (2005) models have become very important tools in understanding money. In this model, money is replaced by a dividend yielding asset, that thus takes the role of medium of exchange and store of value. Is this a good representation of an asset whose pricing behavior Ravikumar and Shao try to replicate? An economy without money may have very different asset dynamics than with money.

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One Response to Search Frictions and Asset Price Volatility

  1. M. H. says:

    Instead of asking why money is missing, why not consider this like an experiment where money is yielding interest? It would satisfy the Friedman Rule…

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