Transaction costs and liquidity

This paper studies the role transaction costs play in determining the liquidity and other equilibrium properties of an economy. Households in the model face a transaction cost every time they alter the composition of their portfolio between cash and interest bearing assets and therefore choose to stagger their trips to the asset market. The cost of transacting directly influences the frequency of these trips and thus the liquidity in each of the economy's markets. We extend the analysis of models in the Grossman and Weiss (1983) tradition by allowing households to endogenously choose the frequency of adjustment of their portfolio when facing different transaction costs. The model is also used to analyze the different responses to monetary shocks of economies with varying liquidity. It is shown that the effect on the economy from unexpected changes in monetary policy depends strongly on the relative liquidity between markets. In particular, when the asset market is relatively illiquid, a money shock has persistent non-neutral effects on both nominal and real variables. Further, the response is shown to depend on the way the shock affects market liquidity. Specifically, only if the shock is modeled as a lump-sum transfer of money (instead of an open market operation) does the model produce the ‘conventional’ liquidity effect (falling nominal and real interest rates following an expansionary monetary shock) found in many empirical studies.