Pledgability and Liquidity: A New Monetarist Model of Financial and Macroeconomic Activity

By Venky Venkateswaran and Randall Wright

When limited commitment hinders unsecured credit, assets help by serving as collateral. We study models where assets differ in pledgability – the extent to which they can be used to secure loans – and hence liquidity. Although many previous analyses of imperfect credit focus on producers, we emphasize consumers. Household debt limits are determined by the cost households incur when assets are seized in the event of default. The framework, which nests standard growth and asset-pricing theory, is calibrated to analyze the effects of monetary policy and financial innovation. We show that inflation can raise output, employment and investment, plus improve housing and stock markets. For the baseline calibration, optimal inflation is positive. Increases in pledgability can generate booms and busts in economic activity, but may still be good for welfare.

When you want to trade today but can only offer a counterpart tomorrow, you either pledge an asset or use some asset as collateral. But this is fraught with frictions, the quality of the asset may be uncertain, for example.Traders should thus endogenously determine how much asset should be used as a medium of exchange or collateral, depending on circumstances. In such a context, inflation in fiat money, which is used for transactions as well , has a positive impact: as the opportunity cost of money increases, agents substitute into other assets and thus increase working capital. Higher steady-state inflation can thus mean higher output. That result is quite difficult to obtain in micro-founded models where the Friedman Rule tends to prevail.

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