This thesis explores money manager intertemporal arbitrage as an explanation of the liquidity effect. We develop a theoretical model of optimal portfolio adjustment by professional money managers, and show that they engage in intertemporal asset price arbitrage; they reduce their holdings of financial assets when they expect asset prices to fall, and increase their holdings when they expect prices to rise. Since a reduction in financial assets can only be accomplished through an increase in money holdings, a connection exists between intertemporal price arbitrage and speculative balances. We show that in equilibrium, money manager behavior causes market liquidity shocks to be accompanied by a form of asset price overshooting in which asset prices first rise above their long-run value and then slowly return as speculative balances are lent out to borrowers and absorbed into transactions balances. Such asset price overshooting is precisely the liquidity effect, stated in terms of asset prices rather than interest rates. This shadows the result established by Hartley (1990), who showed that the combination of sector-specific liquidity shocks and trading rigidities across sectors will cause general price overshooting in those sectors closest to the money supply injection. The second part of this thesis attempts to identify an empirical relationship between speculative balances and asset prices as a means of verifying the hypothesis that money manager intertemporal price arbitrage generates the liquidity effect. It is not possible to estimate this relationship on an aggregate level because no means exist to identify speculative balances relative to the total money supply. However, it is possible to test if individual money managers engage in intertemporal price arbitrage. We do so by estimating individual institutional investor demand for speculative balances. The data source we use is the Flow of Funds, which gives money holdings for various groups of institutional investors. We find an elasticity of 0.1 for speculative balances with respect to the stock market price-earnings ratio
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