Liquidity constraints in a monetary economy

This article presents a microfounded model of money with a consumption and an investment market. We consider an economy in which only part of the investment returns can be pledged. A liquidity constraint arises when the pledgeable part of the returns are not enough to pay for investment costs. We show that when the liquidity constraint is binding, agents may make a cash downpayment and money can perform two roles—as a provider of liquidity services and exchange services. The liquidity constraint constitutes a channel though which underinvestment occurs even at low inflation rates.