Econ Theory (2009) 39:177–194

DOI 10.1007/s00199-008-0343-y

RESEARCH ARTICLE

State prices, liquidity, and default

Raphaël A. Espinoza · Charles. A. E. Goodhart ·

Dimitrios P. Tsomocos

Received: 15 October 2007 / Accepted: 4 February 2008 / Published online: 29 February 2008
© Springer-Verlag 2008

Abstract We show, in a monetary exchange economy, that asset prices in a complete

markets general equilibrium are a function of the supply of liquidity by the Central
Bank, through its effect on default and interest rates. Two agents trade goods and nom-
inal assets to smooth consumption across periods and future states, in the presence
of cash-in-advance financing costs that have effects on real allocations. We show that
higher spot interest rates reduce trade and as a result increase state prices. Hence, states
of nature with higher interest rates are also states of nature with higher risk-neutral

The authors are grateful for suggestions and comments on earlier versions of this paper from Valpy
FitzGerald, John Geanakoplos, Pete Kyle, Herakles Polemarchakis, Oren Sussman, and from participants
at the 2007 Meeting of the Society for the Advancement of Economic Theory (SAET), the 22nd Annual
Congress of the European Economic Association, the Third Monetary Policy Research Workshop in Latin
America and the Caribbean (Banco de la República de Colombia and Bank of England), and workshops at
the Saïd Business School (Oxford) and at the Bank of England. The views expressed in this paper are
those of the authors and do not represent those of the European Central Bank or the Eurosystem.

R. A. Espinoza
University of Oxford, Oxford, UK

R. A. Espinoza
European Central Bank, Frankfurt, Germany

Present Address:
R. A. Espinoza
Christ Church, Oxford, OX1 1DP, UK
e-mail: raphael.espinoza@chch.oxon.org

C. A. E. Goodhart
Financial Markets Group, London School of Economics, London, UK

D. P. Tsomocos (B)
Saïd Business School and St. Edmund Hall, University of Oxford, Oxford, UK
e-mail: dimitrios.tsomocos@sbs.ox.ac.uk

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178 R. A. Espinoza et al.

probabilities. This result, which cannot be found in a Lucas-type representative agent

model, implies that the yield curve is upward sloping in equilibrium, even when short-
term interest rates are fairly stable and the variance of the (macroeconomic) stochastic
discount factor is 0. The risk-premium in the term structure is, therefore, a monetary-
cost risk premium.

Keywords Cash-in-advance constraints · Default · Asset prices ·

Risk-neutral probabilities

JEL Classification E43 · G12

1 Introduction

There is an unresolved lacuna, which is why in representative agent models, with

complete markets, and a transversality condition, in which everyone always pays off
their debts in full with certainty, there is any need for money at all? Why cannot all
exchanges simply be undertaken via book-keeping, with no prior need for an exchange
of money? Why is there a cash-in-advance constraint at all? And what exactly are these
costs of financing?
Our answer to this is that the most egregious assumption is the transversality con-
dition. Once one allows for the possibility of default by the buyer of the good, who
becomes a debtor to the seller, the seller will no longer be prepared to accept the buyer’s
IOU. She will want, instead, a safe asset, which will be more generally acceptable in
subsequent transactions, i.e. money. Moreover, financing costs involve assessing the
credit-worthiness of the buyer of a good, or of an asset, and of the IOU which he
may be proffering as a counterpart to the purchase (n.b., even cash needs inspection
to avoid forgery, and bank drafts and cheques may be defaulted).
Incorporating default into a model is complex. Not only is the event of default
non-linear, but the existence of positive default is hardly consistent with many of the
elements of the kind of theoretical models which are commonly in use, involving com-
plete markets, no aggregate uncertainty and representative agents (meeting the trans-
versality conditions). Although incomplete markets and default are ultimately essential
for the actual phenomenon of monetary and financial dealings that we observe, we
make one small step towards reality by incorporating default in a complete markets
setting with money, and we analyse the consequences of such a monetary model for
state prices.
As a concrete example, a long standing puzzle is the fact that the forward term
premium (i.e. the difference between the forward rate and the expectation of the cor-
responding future spot rate) has empirically been positive. In the absence of arbitrage,
with complete markets, no transaction costs, unsegmented markets, and equal tax
treatment, an increasing term structure is possible if and only if instantaneous forward
rates are increasing.1 The history of upward sloping term structure implies increasing
forward rates, and therefore, assuming the expectation hypothesis with risk-neutrality,

1 At time t, the yield of a long-term bond maturing at T is equal to the simple averages of the instantaneous
forward rates (see Shiller 1990 p. 640).

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State prices, liquidity, and default 179

increasing expected future spot rates—something that does not correspond to the his-
torical evolution of short-term interest rates.
Are rational expectations failing and bond markets inefficient then? The early liter-
ature on the term structure had tried to explain this puzzle by appealing to liquidity or
risk. Hicks (1946) emphasized that a risk-averse investor would prefer to lend short-
term, if he was not given any premium on long-term lending, because there is a higher
risk that the prices of long-term bonds change. Lutz (1940) suggested that long-term
securities are less liquid than short-term ones, where the most liquid asset is money.
Finally, Modigliani and Sutch (1967) proposed the preferred habitat hypothesis—a
theory that has been very influential—arguing that agents prefer to hold bonds to
match asset and liability maturities. Hence, the markets for long-term and short-term
bonds would be segmented, at least to some extent, and therefore the link between
long and short-term interest rates might break down.
The modern literature has emphasized the importance of aggregate risk, following
Lucas (1978). In these representative agent models, the forward interest rate is higher
than the expected spot rate because of risk-aversion. The risk-premium is shown to be
proportional to the correlation between marginal utility and the payoff of the asset
(Breeden 1979). Since high interest rates tend to depress activity, the correlation
between the payoff of a bond and marginal utility is likely to be significant.
Put differently, asset prices2 are proportional to future marginal utilities (Breeden
and Litzenberger 1978). The application of this model to the term structure is due to
Backus et al. (1989) who conclude, in the vein of Mehra and Prescott (1985), that the
term premium is underestimated in Lucas-type artificial economies.
In the present paper, we argue that aggregate consumption risk is not the only
source of risk-premia in asset prices. An additional risk-premium exists because of
the effect of financing costs on marginal utilities. This risk-premium cannot be cap-
tured by representative agent models because this premium exists even in absence
of aggregate uncertainty (i.e. endowments and aggregate consumption are constant).
We model financing costs with cash-in-advance constraints. The risk-premium exists
for any asset even when aggregate real uncertainty is nil. We set out a monetary
general equilibrium model with cash-in-advance constraints. The monetary theory
literature generated many models, with various conclusions on the existence and
uniqueness of equilibrium. Our model is an exchange economy built along
the lines of Dubey and Geanakoplos (1992), Geanakoplos and Tsomocos (2002),
Tsomocos (2003, 2008) and Goodhart et al. (2006), where the cash-in-advance con-
straints and a combination of inside and outside money ensure nominal and real
determinacy, even in incomplete markets. These models are finite horizon models.
Exchange economies with money and infinite horizons have also received some atten-
tion in the recent years (for instance Bloise et al. (2005), Bloise (2006) present a
complete markets infinite horizon monetary economy, whereas Santos (2006) anal-
yses the value of money in an incomplete markets economy). In these models, the
monetary equilibrium is not always unique because agents are not endowed with out-
side money.

2 Or equivalently risk-neutral probabilities, which are by definition proportional to the Arrow prices.

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180 R. A. Espinoza et al.

We need a general equilibrium model with nominal and real determinacy because
we want to endogenise all demands for money in order to construct the Arrow prices
and their associated risk-neutral probabilities. In addition, we allow for default in the
money market à la Shubik and Wilson (1977) as a friction that is equivalent to the
existence of outside money in Dubey and Geanakoplos (1992, 2006). The combina-
tion of default and cash-in-advance constraints generate a proper demand for liquidity
and a unique positive intra-period interest rate. This rate represents a “loss reserve
payment protecting the bank against default” (Shubik and Wilson 1977), rather than a
pure asset price. It is crucial for our model because it corresponds to a financing cost
that generates a wedge between buying and selling prices.
We assume that all states are equiprobable both in reality and as understood by the
investors (i.e. subjective probabilities are uniform and beliefs are correct and homoge-
neous across agents). This way, we exclude the issue of agents’ utility heterogeneity (an
issue covered, for instance, in Fan 2006). We price nominal Arrow–Debreu securities
(AD securities). The strong assumption of complete markets is needed here because
we want to solve for all AD securities’ prices. For instance, if the prices of AD secu-
rities were constant through all states of nature, then the historical average of spot
interest rates that would proxy rational expectations without risk-premium Et [rt,t+s ]
would be equal to the expected interest rate Eπ [rt,t+s ] using risk-neutral probabilities
π . However, we will show that this is not the case in our model, even though there is
no real uncertainty.
The main result of the paper is that states with higher interest rates (lower liquidity
supplied by the Central Bank) have higher state prices. Intuitively, since we model
consumer’s utility with a Cobb–Douglas specification with equal weights on all states
of nature, the cost of consumption is constant across all states. This cost of consump-
tion is equal to the opportunity cost to transfer money (i.e. the AD security price) from
period 0 to the next period, called f , multiplied by the value of trade in period f (i.e.
the price of the good multiplied by the volume traded). In period f , if state 1 has more
liquidity than state 2, the value of trade in state 1 has to be higher than the value of
trade in state 2, because the quantity theory of money holds in our cash-in-advance
model. With the Cobb–Douglas utility function assumption, this is possible only if
the cost of transferring money in state 1 (i.e. the price of a claim with state-contingent
payoff, also called the state price) is lower than the cost of transferring money in state
2. Therefore, a state with lower interest rate (higher liquidity) is also a state with lower
state price (and therefore lower risk-neutral probability).
The lesson of the model is that uncertainty in aggregate production or in aggre-
gate consumption is only one part of uncertainty in agents’ marginal utilities. Bansal
and Coleman II (1996) produce a representative agent general equilibrium model with
transaction costs that partly capture this effect on bond prices. However, in their model,
trade is forced, since the representative agent sells all of his endowment and subse-
quently buys it back, and the transaction cost function is exogenously specified. In
particular, transaction services are generated only from bond holdings and not from
asset holdings, and this is how the authors show that the equity premium may be large.
Lucas (1990) also constructs a model of liquidity, derived from Lucas and Stokey
(1987), and identifies the regimes in which the representative agent is constrained by
her money holdings in her ability to trade assets. In the liquidity constrained regime,

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State prices, liquidity, and default 181

when bond supply changes, Lucas shows that equilibrium requires that all adjust-
ment be borne by prices. This is because nominal demand is predetermined by money
holdings. As a result, the short-term interest rate is more volatile than the Fisherian
fundamentals. Our paper shares some common points with Lucas (1990). In particular,
asset purchases are also restricted by liquidity, and as a result, the inter-period bond
prices cannot be deduced from the Fisherian fundamentals. However, the liquidity
channel differs. In Lucas (1990), the marginal rate of substitution is kept constant, and
the effect is through bond prices. In our paper, the main effect is through changes in
the value of trade, which is endogenous, and in the agents’ marginal utilities (although
the aggregate economy’s marginal rate of substitution is determined by endowments).
In other words, unlike in Lucas (1990), a non-trivial quantity theory of money obtains
whereby both prices and quantities vary whenever liquidity changes.
In our model, uncertainty about future financing costs and trade volumes matters,
and is endogenously derived. Therefore, any model of risk-premium that attempts to
proxy welfare by aggregate measures of production or consumption will poorly esti-
mate risk-premia. This is especially important for the term premium since the spot
interest rate has both an effect on the asset price and on the inter-temporal financing
cost. In that case, the correlation between the marginal utilities and the asset price is
likely to be high. The risk-premium will be erroneously underestimated.
The model is an exchange economy with cash-in-advance constraints where a larger
money supply generates a higher price level, increases the cost of default, since default
penalties are assumed to be fixed in nominal terms, and therefore reduces the rate of
default. This lowers the intra-period interest rate. (Note that a model with real default
penalties would leave this result unchanged. In that case, higher money supply would
increase trade and thereby lower the marginal utility of consumption. Thus, the opti-
mising consumers, who equalise marginal utility of consumption and marginal cost
of default, would want, in equilibrium, to have a lower cost of default, and hence
reduce the size of default. Moreover, since actual bankruptcy law is based on nominal
defaults, and is updated with long lags, the assumption of nominal default penalties
seems more realistic, especially in the short-term.)
In either case, more money supply allows for more efficient trade since financing
costs are lower. Efficiency is established when money supply is large enough to push
default rates to zero.3 Cash-in-advance models have several drawbacks—in particular,
money supply is exogenously given—however, the advantage of the cash-in-advance
constraint is that it allows us to incorporate markets for AD securities together with
markets for money, even in a finite-horizon model.
The presence of default serves in this paper the same role as the existence of outside
money in Dubey and Geanakoplos (1992). Arguably, liquidity (in any way defined)

3 For this to be true, it is necessary for inflation to be costless. The Lucas Parable and price and/or wage
stickiness are two ways to generate costly distortion of relative prices because of inflation. We assume
costless inflation in this paper because the focus is on liquidity and efficiency.

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182 R. A. Espinoza et al.

2-Period Model

mi > 0

Default

Money Market Equilibrium

Positive Interest Rate

r i = di
For a given interest rate, there positive buying and selling
exists a unique money demand price wedge

Nominal Determinacy Financing costs

u’(ci) / u’(c0) = pi qi / [p0(1+ri)]

Determinacy of State Prices Changes in monetary conditions

qi = M0 / (n Mi) have real effects

Real payoffs of Arrow securities

are a function of liquidity

Fig. 1 2-Period model

becomes important and has real effects whenever default in the economy is present.
We use therefore default in this paper to ensure a positive interest rate and a positive
value for money. Money has then an effect on asset prices and payoffs through both
nominal and real channels. This is summarised in Fig. 1. Let us examine the nom-
inal channel first. A positive interest rate ensures that there exists a unique money
demand, equal to money supply, thus leading to a unique interest rate that clears the
credit market. Consequently, the price level is pinned down. This is in stark contrast
with dichotomous models where, since money has no value, any money demand (and
therefore any price level) can constitute equilibrium. However, when the indetermi-
nacy on price levels is removed, asset prices are also uniquely determined (we show
indeed that they are inversely related to liquidity, which answers our term structure
puzzle). Money also has an effect through the real channel, because positive interest
rates create a wedge between buying and selling prices and, therefore, distort marginal
rates of substitution. This is the source of non-neutrality of money. In particular, trade
and prices are typically higher with more liquidity. This in turn has an effect on the
real asset payoffs.
This allows us to show the existence of a “liquidity-premium” that comes from the
additional cost incurred by investors (and priced in the term structure) that an uncertain
money supply will generate when liquidity is restricted. Note that the level of money
supply does not really matter: in the long run, if prices adjust to the money supply,

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State prices, liquidity, and default 183

provided that default penalties adjust accordingly, constraints on liquidity do not have
real effects. However, what still has effects is the variance (or risk) of liquidity. This
is exactly what is captured in the model, where we show that larger liquidity risks
generate higher long-term interest rates. Stricto senso, our model is therefore a model
of the “liquidity-risk premium”. This liquidity risk-premium is deduced immediately
from the previous section, since Arrow prices (and therefore risk-neutral probabilities)
are high when the interest rates are high. The existence of the liquidity-risk premium
has at least two consequences. First, the term structure is upward sloping beyond what
is expected from the pure expectation hypothesis even if the Lucas-type risk-premium
is incorporated. Second, stability of monetary policy matters because monetary policy
also affects risk-neutral probabilities.

2 The model

The model is an exchange economy without production. Trade takes place between
two agents who want to trade across periods (for consumption smoothing purposes)
and across states (because of risk-aversion). Because cash is needed before commod-
ity transactions, and because receipts of sales cannot be used immediately to buy
commodities (the timing of the markets’ meetings is represented in Fig. 2), agents
require cash as a derived demand due to their transaction needs. Liquidity is supplied
exogenously by the Central Bank who can diminish short-term financing costs by
increasing money supply. A decrease in financing costs improves trade and Pareto
efficiency.
The model is built around two periods, period 0 (now) and period f (future). Peri-
ods are divided into sub-periods at which the different commodity and money markets
meet, as pictured in Fig. 2. The state of nature is revealed after the closure of the money
market and default settlement in period 0, and before the opening of the money market
next period. Likewise, default settlement in the future occurs after the closure of the
money market. Since the goal of the paper is to study the consequences of uncertainty
of monetary policy rather than its determinants, we assume money supply is exogenous

t = 0 (present) t = f (future)

Inter-period trade in Arrow securities

Arrow securities Arrow securities

Market Commodity Market Commodity
Market Market

Intra-period money market loan Intra-period money market loan

Money supply M0 Money supply Mi

Fig. 2 Timing of the model

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184 R. A. Espinoza et al.

Fig. 3 Endowment and asset structure

and random.4 There are n states of nature possible, indexed by i ∈ N = {1, . . . , n}

and with subjective probabilities all equal to n1 . The Central Bank thus provides money
for:
– the short-run period-0 money market, with money supply M0 , interest rate r0 and
bond price η0 = 1+r1
0
– ∀i ∈ N the state-i money market, with money supply Mi , interest rate ri and
bond price ηi = 1+r1
i

As already noted, money supply has an effect on the cost of default and therefore on
default and interest rates. In equilibrium, we will show that interest rates are negatively
related to the Central Bank money supply (see below). In addition to these n +1 money
markets, the two agents can trade n Arrow–Debreu securities (ADi )1≤i≤n that give 1
in state i and 0 in all other states j = i. All Arrow–Debreu securities are available
for trade (but in zero net supply) and therefore financial markets are complete with
this structure. Figure 3 presents the agents’ endowments and the available assets in the
model. Knowing the interest rates, we will compute the AD security prices and show
how they are related to interest rates. The first step is however to ensure a positive value
for money and nominal determinacy using a cash-in-advance model with default.

2.1 Cash-in-advance models and the value of money

Cash-in-advance models5 aim at capturing the importance of liquidity for transactions.

To ensure a positive nominal interest rate, a sufficient requirement is that agents hold

4 One could think of a Central Bank operating on a metallic (e.g. gold) standard. Its holdings would be
increasing with new deposits, or with less metal withdrawn for non-monetary uses. Its loans would have to
be proportional to its metallic base, whose amount is subject to exogenous and unpredictable shocks from
the variations in the supply and demand for such metallic monetary base. This is a reasonable representa-
tion of reality until 1914. Since the era of “managed money” began, however, the analyst should also be
concerned about the Central Bank’s objective function, the private sector’s expectations of Central Bank
action, etc., but these latter (valid) complications are not necessary for the demonstration of the theoretical
issues addressed here.
5 The modern treatment of cash-in-advance models dates as far back as Clower (1967).

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State prices, liquidity, and default 185

some exogenous endowment of money (called outside money), and this has been a
common treatment in monetary theory, from Gurley and Shaw (1960) to Dubey and
Geanakoplos (1992, 2006). In these models, if M is the supply of money by the Central
Bank, and if outside money endowed to the agents is m, in equilibrium, borrowing is
equal to M and repayments to M + m.6 As a result, the nominal interest is r = M m
.
Although an exogenous endowment of money can be justified in a one-period model,7
this assumption is harder to maintain in a multi-period setting. In fact, one should
think of outside money as a compact simplification for a more general nominal fric-
tion that pins down the price of money. Default on the money market can, indeed,
play the same role as outside money to ensure the existence of a positive interest rate.
Shubik and Tsomocos (1992) model endogenous default, and generate positive inter-
est rates. We draw here a simpler model with endogenous default and show that the
interest rate is approximately equal to the default rate (see below). If the default penalty
is low enough, default rates, and hence interest rates will be positive.
For the sake of simplicity, we allow for default only in the money markets, but
not in the asset markets. Since in our model markets are complete, had we allowed
for default in the asset markets, the only effect would be on the Arrow–Debreu state
prices. This would be the case because the asset span would remain the same, thus no
real effects would be generated.
Default is both strategic as well as due to ill-fortune. Even though agents rationally
decide how much to default in each state of nature ex ante, the actual default is deter-
mined in equilibrium after the resolution of uncertainty ex post. Therefore, default
naturally emerges from the strategic consideration of agents under uncertainty.
Positive interest rates (as already noted in the introduction) are key to the model
because they both ensure nominal determinacy, which is required for a theory of the
term structure, and also create financing costs which affect real variables. Positive
interest rates therefore help to determine both the slope of the yield curve and the real
payoffs of assets.

2.2 Budget set for agent α

There are two agents in the model. For any period or state of nature, each agent can
pay b units of money to buy b/ p units of good, or can sell q units of good and receive
pq units of money. Hence, consumption in each period or state is

b
c =e−q +
p

keeping in mind that either q = 0 (if the agent wants to buy) or b = 0 (if the agent
wants to sell), in this one-commodity economy.
Agent α does not own any good in period 0 but owns e > 0 units of the consumption
good in the future, where e is non-random. (Variables without supscript refer to agent α,

6 Since no one would want to keep money holdings at the end of the model’s horizon.
7 Outside money may be inherited from previous periods and free from any debt requirement outstanding.

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186 R. A. Espinoza et al.

who will be the borrower—while variables with supscript ∗ will refer to agent β, who
will be the lender). Agent α maximises an inter-temporal Von Neumann-Morgenstern
utility function with discount factor 1, equal weights between the n-states (since the
states are assumed to be equi-probable) and logarithmic felicity function u.
In period 0, agent α sells qADi securities at price θi to finance consumption at
time 0. This is equivalent to saying that agent α borrows with repayments conditional
on the state of nature i.
In the future, in state i, agent α has to to give qADi (the state-contingent repay-
ment) to agent β who—as we will see later—has bought the AD securities. Since
µi
agent α cannot yet use the receipts of the goods he is about to sell, he borrows 1+r i
from the Central Bank (i.e. rolls over his debt) to pay agent β the qADi he owes him
from the ADi -security. He can then use the receipts of his sales ( pi qi ) to repay the
short-term loan µi that he had contracted with the Central Bank. However, agent α
defaults on a share di of his repayments to the Central Bank and does not repay the
whole loan. He, therefore, repays only µi (1 − di ) to the Central Bank. Agent α incurs
a utility cost from the total value defaulted, di µi , as in Shubik and Wilson (1977).
To summarise, agent α’s maximisation programme is (in brackets are the lagrangian
multipliers)8
⎛ ⎞


b0 1 ⎝
max ln + ln(ei − qi ) − λ max(di µi ; 0)⎠ (1)
b0 ,(qi ,µi ,qADi ,di )i∈N p0 n
i∈N


s.t. b0 ≤ θi qADi (ϕ) (2)
1≤i≤n
∀i ∈ N qADi ≤ ηi µi (i ) (3)
µi (1 − di ) ≤ pi qi (χi ) (4)

2.3 Budget set for agent β

Agent β is endowed with e0∗ units of the good in period 0, but has nothing in the future.
He has the same preferences as agent α.
In period 0, he sells q0∗ to agent α and wants to invest it for next period consump-
tion, lending to agent α with repayments conditional on the state of nature (i.e. he buys
AD securities bAD∗ ).9 However, he will receive the cash only at the end of period 0,
i
µ∗0
after the securities market meets. Hence, he first borrows 1+r0 to the Central Bank.

8 We do not allow explicitly in these equations for the possibility that agents α carries money over from
period 0 to period f because we only study interior equilibria where all constraints are binding. Also, we
will later assume di > 0, although we do not write this constraint into the maximisation problem.
9 We do not make explicit the possibility for agent β to carry money over since he will never do so, since we
will show that all constraints are binding. As a result, all the receipts from the sales of good 0 are invested
in AD securities, and this means that agent β borrows short-term from the Central Bank as much as he will
be able to repay.

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State prices, liquidity, and default 187

He will repay the loan with the receipts of his sales p0 q0∗ . Since agent β also defaults
by d0∗ , he in fact will repay only µ∗0 (1 − d0∗ ).
In state i, he receives the state-contingent repayments from agent α (i.e. he receives
∗
bAD
i b∗
θi from each ADi -security) and he uses this to buy pii units of the consumption good
(at total cost bi∗ ). To summarise, agent β’s maximisation programme is:

∗
1  b
max∗ ln(e0∗ − q0∗ ) + ln i − λ max(µ∗0 d0∗ ; 0) (5)
q0∗ ,(bi∗ ,bAD ,µ0 ,d0∗ )1≤i≤n
∗ n pi
i 1≤i≤n


∗
s.t. bADi
≤ η0 µ∗0 (ϕ ∗ ) (6)
1≤i≤n
µ∗0 (1 − d0∗ ) ≤ p0 q0∗ (ξ ∗ ) (7)
b∗ADi
∀i ∈ N bi∗ ≤ (χi∗ ) (8)
θi

2.4 Monetary equilibrium

A Monetary equilibrium is reached when:

(i) Agents maximise utility, as described above
(ii) Commodity markets clear, i.e.

b0
p0 = ⇐⇒ p0 q0∗ = b0
q0∗
b∗
∀i ∈ N pi = i ⇐⇒ pi qi = bi∗
qi

(iii) Money and AD security markets clear, i.e.

µ∗0 = (1 + r0 )M0 = M0 /η0

∀i ∈ N µi = (1 + ri )Mi = Mi /ηi
∗
∀i ∈ N θi qADi = bAD i

3 Interest rates and the quantity theory of money

Equilibria in our model may be with, or without, active default. In the latter case,
the interest rates will be equal to zero and, consequently, prices would be indetermi-
nate since agents could leave some cash unused and prices would adjust appropriately
without disturbing real allocations. Default would be prevented with a sufficiently
harsh default penalty as in Shubik and Tsomocos (1992). In the former case, however,
positive default ensures positive interest rates that remove the nominal indeterminacy.
Indeed, default can be seen as “monetary injections” to the agents participating in the

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188 R. A. Espinoza et al.

short-run markets. These monetary injections are endogenously determined, unlike

in Lucas (1990) where they are exogenous. Thus, endogenous default affects and is
affected by quantities traded.10
The following propositions determine the value of money and are consistent with
the quantity theory of money in a cash-in-advance model with active default. Proposi-
tion 1 shows that short-term interest rates are inversely related to the supply of money
by the Central Bank. Proposition 2 shows that the Quantity Theory of Money holds
in a liquidity-constrained economy, i.e. that nominal activity is equal to the supply of
money.

Proposition 1 (Short-term interest rates)

r0 ≈ d0∗ = 1 − λM0
∀i ∈ N ri ≈ di = 1 − λMi

Proposition 2 (Quantity theory of money)

p0 q0∗ = b0 = M0
∀i pi qi = bi∗ = Mi

Proof From the market-clearing conditions, and for an interior equilibrium,

 
∗
b0 = θi qADi = bADi
= η0 µ∗0 = M0
1≤i≤n 1≤i≤n

Similarly,

bi∗ = bAD
∗
i
/θi = qADi = ηi µi = Mi

which proves Proposition 2. Furthermore:

p0 q0∗ 1
(1 + r0 )M0 = µ∗0 = ∗ = M0
1 − d0 1 − d0∗

Therefore

1
1 + r0 =
1 − d0∗

or

r0 ≈ d0∗

10 Trade is itself determined by the quantity of money, which is why only money supply appears in
Proposition 1.

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State prices, liquidity, and default 189

Similarly, ∀i ∈ N

ri ≈ di

which proves the relation between interest rates and default. The link between
default and money supply is taken from Eq. 19 in the closed-form solution of the
model (Theorem 2).

Hence, money supply has an effect on the interest rate through the amount of default.

4 Financing costs and state prices

This section shows how the marginal utilities and financing costs affect equilibrium
state prices. We are only interested in the properties of the interior equilibria, and
hence we assume that the constraints are binding, which implies that no money is
carried over.

Theorem 1 (Endogenous state prices) In an equilibrium, states with higher interest

rates correspond to higher state prices (i.e. bigger risk-neutral probabilities).

Proof Denote L the lagragian formed from β’s maximisation problem. The first order
conditions for agent β are:

∂L −1
= ∗ + p0 ξ ∗ = 0 (9)
∂q0∗ e0 − q0∗
∂L 1 1
∀i ∈ N = − χi∗ = 0 (10)
∂bi∗ n bi∗
∂L
= −λd0∗ + η0 ϕ ∗ − (1 − d0∗ )ξ ∗ = 0 (11)
∂µ∗0
∂L ∗ χi∗
= −ϕ + =0 (12)
∂b∗ADi θi
∂L
= −λµ∗0 + d0∗ ξ ∗ = 0 (13)
∂d0∗

And therefore, we deduce

θi bi∗ = θ j b∗j . (14)

Since we know, from Proposition 2, that b∗j = M j and Mi = bi∗ , and since interest
rates are inversely related to liquidity (from Proposition 1):

r j < ri ⇐⇒ M j > Mi ⇐⇒ b∗j > bi∗ ⇐⇒ θ j < θi

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190 R. A. Espinoza et al.

The intuition of this result is straightforward. Since we model consumers’ utility with
a Cobb–Douglas specification with equal weights on all states of nature, the cost of
consumption is constant through all states (see Eq. 14). This cost of consumption is
equal to the cost of transferring money from period 0 to period f (i.e. the AD security
price) multiplied by the value of trade in period f (i.e. the price of the good multiplied
by the volume traded). The value of trade is equal to the overall supply of liquidity
because the quantity theory of money holds. For example, if there is more liquidity
in state 1 than in state 2, the value of trade in state 1 has to be higher than the value
of trade in state 2. However, according to Eq. 14, this is possible only if the cost of
financing consumption in state 1 is lower than the financing cost in state 2. Therefore, a
state with lower interest rate (higher liquidity) is also a state with lower inter-temporal
financing cost (i.e. lower state price).
We can equivalently work with the risk-neutral probabilities

θi
πi =  (15)
1≤k≤n θk

and show that

∀i = j r j > ri ⇐⇒ π j > πi (16)

This is the main result of our model. It first shows how Arrow prices (and risk-neutral
probabilities, which are proportional to Arrow prices) depend on money supply. Fur-
thermore, the fact that states with higher interest rates are given higher weights and
resolves the term premium puzzle stated in the introduction, without violating the
rational expectation hypothesis. A comparative statics version of this result is possi-
ble, with a logarithmic version.

Theorem 2 (Comparative statics) With this logarithmic utility function, an increase

in state-i interest rate increases the risk-neutral probability (or the Arrow price) asso-
ciated with this state.

Proof We can easily find a closed-form solution with logarithmic utility. We show in
fact that the state price is θi = nMM0i . We first compute state prices. From Eq. (8)


∗
bAD k
= M0 (17)
1≤k≤n

Since ∀i, k ∈ N ∗
bAD = θk bk∗ = θi bi∗ = bAD
∗
k i


∗
∀i ∈ N bAD k
= nθi qADi = M0 (18)
1≤k≤n

M0 M0
Hence θi = nqADi = n Mi because qADi = Mi .

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State prices, liquidity, and default 191

We now solve for default, prices and trade volumes. From agent α first-order conditions
(the computations of agent α’s first-order conditions are left to the reader):

1 ηi θi ϕ − λ/ndi θi λdi
χi = = = −
npi (ei − qi ) 1 − di b0 n(1 − di )

Furthermore, we know that χi = λn , qi = Mi / pi and b0 = M0 . Hence,

1 λdi
− =λ
Mi (1 − di )

which implies
di = 1 − λMi (19)
Since di is constrained to be positive, we have 0 ≤ di < 1, and di is decreasing with
Mi . This is important as di ≈ ri . Therefore, an increase in money supply decreases
the spot interest rate. We can also solve for prices and quantities:

1 Mi 1 + 1
λMi
λ= ⇐⇒ pi =
pi ei − Mi ei

Since λMi = 1 − di = 1
1+ri ,

Mi (2 + ri ) ei
pi = and qi = (20)
ei 2 + ri

Finally, with positive interest rates the liquidity-based market transactions introduce
a “price wedge” in asset trading, the size of which depends on period zero interest rates.
The complication that positive interest rates introduce is the failure to have an exact
linear pricing rule of assets. In Tsomocos (2003), it is shown that if an asset j’s payoffs
can be replicated by buying asset 1 (with price φ1 ) and selling asset 2 (with price φ2 ),
then the price φ j of asset j is such that φ1 − (1 + r0 )φ2 ≤ φ j ≤ φ1 − 1/(1 + r0 )φ2 .

5 Interpretation and real asset payoffs

The model excludes aggregate endowment uncertainty by setting ei = e. So, our result
is not simply a version of the risk-premium found in pure exchange general equilib-
rium models with heterogeneous agents or in a representative agent model (Lucas
1978; Breeden 1979). Indeed, the endowment risk-premium has been removed in our
model, and state prices are only a function of money. However, the model still exhib-
its a risk-premium, since risk-neutral probabilities are higher in states of nature with
higher spot interest rates. As will be demonstrated, the additional risk-premium has

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192 R. A. Espinoza et al.

both a nominal and a real component. When ri is high, activity (i.e. qi ) is low (Eq. 22).
The fact that the state prices are ratios of money supplies, i.e.

1 M0 1 r i M0
θi = = (21)
n Mi n di

shows why the risk-premium is, in part, a nominal risk-premium: state prices are higher
for states with low money supply simply because the value of money increases. How-
ever, real variables and marginal utilities are also affected by changes in the money
supply.
It is, however, not possible to link directly state prices and the effect of money on
marginal utilities, because the model is not a representative agent model. When ri is
low, because qi is high, agent α’s marginal utility is low, but agent β’s marginal utility
is high. This is why we need to look at the demand and supply of assets to solve for
state prices, and we proved in Theorem 1 that the nominal state price θi is low when
ri is low. One can also show that pi1θi , the real payoff of an Arrow–Debreu security is
decreasing when the spot interest rate ri increases. This is easily seen since the price
level is
Mi (2 + ri )
pi = (22)
ei
Therefore, the real payoff of the ith Arrow–Debreu security is:

1 ei ei
= =
pi θi (2 + ri )Mi θi (2 + ri )M0 /n

and is clearly decreasing in ri . The fact that the asset’s real payoff is lower when
the interest rate is higher confirms that the risk-premium also includes a real compo-
nent. This real component comes from the allocation uncertainty created by monetary
shocks in a model where money is not neutral.
A representative agent model is unable to reproduce such a result if there is no aggre-
gate real uncertainty (aggregate endowment or aggregate consumption is ei + ei∗ =
ei = e = qi + (ei − qi )). The upshot of our argument is that uncertainty in aggregate
production or in aggregate consumption is only one part of uncertainty in agents’ mar-
ginal utilities. Financing costs also generate variability of marginal utilities (and there-
fore of asset demands) in the future. Therefore, any model of risk-premia that attempts
to proxy welfare by production or consumption will underestimate risk-premia. This
is especially important for the term-structure risk premium since the spot interest rate
has both an effect on the asset price (inter-temporal financing cost) and on the short-
term financing cost. In that case, the correlation between the marginal utilities and the
asset price is likely to be high. The risk-premium will be under-estimated.

6 Concluding remarks

In a state with low liquidity, trade has to be low, and, in order to induce consumers to
trade at such a low level, the opportunity cost of transferring money to this state must
be high. This inter-temporal financing cost is equal to the state price. Therefore, state

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State prices, liquidity, and default 193

prices (and risk-neutral probabilities which are proportional to state prices) are higher
in states with higher interest rates. This result is due to the interaction of the money
market (the quantity theory of money) with the exchange economy (the maximisa-
tion problem), and so cannot be found in a pure financial model. Ultimately, it is the
uncertainty in the supply of money that matters to determine the risk in trade values;
and because of the Von Neumann–Morgenstern Cobb–Douglas utility function, it is
trade values (i.e. nominal trade as opposed to real trade) that are equalised through
states. Our result is therefore more general and can be found in any model with com-
plete markets, Von Neumann–Morgenstern utility, some form of the quantity theory of
money, and some transaction cost effect on trade. Other shocks different from liquidity
shocks may, of course, also affect the transaction technology, and hence risk-neutral
probabilities. Liquidity shocks are, however, crucial to understand the upward sloping
term structure because two factors push in the same direction. First, future spot interest
rates are affected; second the risk-neutral probabilities are modified. The interaction
of these two effects pushes long-term rates above the historical average of future spot
rates, even with nonexistent aggregate real risk. The more uncertainty in the future spot
rates, the higher will be the long-term rates. Stability of monetary policy is, therefore,
required to maintain flat yield curves.

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