Liquidity and asset prices: A new monetarist approach

•An economy where defaulters lose collateral and exclusion occurs probabilistically.•A higher exclusion probability implies better enforcement.•Advances in enforcement raise loan-to-value ratios, while reducing asset prices.•Liquidity and output increase with enforcement when the technology is efficient enough.•Inflation raises loan-to-value ratios when enforcement is good enough.

When lenders cannot force borrowers to repay debts, assets are often pledged to secure loans. In this paper borrowers lose collateral once they renege on debts, and exclusion of defaulters occurs probabilistically, with a higher probability implying better enforcement. Increased efficiency in enforcement reduces asset prices, while raising loan-to-value ratios. If the rise in loan-to-value ratios is the dominant effect, aggregate liquidity and output increase with the advance in enforcement. Inflation raises the repayment cost by increasing the loan rate, while raising the default cost through exclusion. Consequently, inflation raises loan-to-value ratios and output only when enforcement is sufficiently efficient.