#05-09
Liquidity, Interest and Asset Prices
Douglas Gale
Abstract: A stylized theory of money and central banking is added to a model of competitive
equilibrium in asset markets to explain the determination of the general level of
asset prices and interest rates. The cash-in-advance constraint provides a transactions
demand for money, but this is not sufficient to guarantee the determinacy of the price
level if liquidity is costless or the price level is uncertain. The central bank plays a
crucial role in determining interest rates and asset prices both as a supplier of liquidity
and through its operation in the goods and asset markets. An extension of the model
to allow for segregated markets can be used to show the impact of monetary policy on
real asset prices and on asset-price volatility. The application of these ideas to financial
intermediation, financial crises and bubbles is briefly discussed.
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