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I am currently reading Alvarez, Lucas, Weber (2001) where the authors argue that changes in money supply is more important for affecting inflation, than changes in the interest rate. However, I am confused about this part:

To be useful in thinking about the role of interest rates and open market operations in the control of inflation, a model of monetary equilibrium needs to deal with the fact that most coherent monetary theories do not have anything like a downward sloping demand for nominal bonds: With a complete set of financial markets, it is just not true that when the government buys bonds, the price of bonds increases. We may believe that such a “liquidity effect” occurs in reality (though it is hard to see it in the data) and may regard it as a deficiency that so much of monetary theory ignores it, but the fact remains that one cannot take take a Sidrauski (1967), Brock (1974), or Lucas and Stokey (1987) model off the shelf and use it to think about increases in money reducing interest rates.

How come when the government purchases bonds, the price of said bond doesn't increase? The authors argue that with an unsegmented market, this does will not happen (i.e there will be no liquidity effect). However, when markets are segmented there is a liquidity effect. The market is segmented in to two groups, traders (have access to the bond market and goods market) and non-traders (only trade in the goods market).

They do develop a model and I more or less understand the mathematics behind it. They show the phenomenon mentioned above using their model. However, I don't quite understand the intuition behind it. Why is there no liquidity effect when markets are unsegmented? Why don't bond prices rise with government purchases?

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The reason why supply effects would not occur is the result of market efficiency assumptions: all financial assets have the same expected returns. Within the bond market, that would imply that the "term premium" is zero.

If the term premium is zero, then:

  • The value of the 1-period "bond" is the result of the central bank reaction function. (The policy rate.)
  • The value of a 2-period bond is determined by the 1-period yield, and the unbiased expectation of the 1-period yield, 1-period forward.
  • (Build up rest of curve similarly.)

They added market segmentation as a way of allowing bonds to trade away from the predicted ('efficient") value, that is, allow a non-zero term premium. Once we allow for a non-zero term premium, supply effects can be seen in predicted bond pricing.

The term premium interacts with supply as a positive term premium will induce bond investors to increase the holdings of bonds relative to the allocation that would happen if the term premium were zero. That is, changes in the term premium is needed to balance the market.

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