Endogenous State Prices and the Yield Curve Raphael Espinoza § and Dimitrios P. Tsomocos ‡ October 2006 Abstract We show, in a general equilibrium model with liquidity constraints, that state prices in a complete market are a function of the supply of liquidity by the Central Bank. In our model, derived along the lines of Dubey and Geanakoplos (1992), two agents trade goods and Arrow-Debreu securities (AD securities) to smooth consumption across periods and future states. Therefore the prices of the AD securities depend on the supply of liquidity in each state. We show that, with Von Neumann-Morgenstern utility functions, the price of an AD security (and therefore the state price or equivalently the risk-neutral probability) is inversely related to liquidity. The upshot of our argument is that agents’ expectations computed using risk-neutral probabilities give more weight in the states with higher interest rates. Thus, an upward yield curve, even though short-term interest rates are fairly stable, can be supported in equilibrium. Keywords: cash-in-advance constraints; risk-neutral probabilities; state prices; term structure of interest rates JEL Classification: E43; G10 § Department of Economics and Christ Church, University of Oxford, email: raphael.espinoza@chch.ox.ac.uk ‡ Saïd Business School and St Edmund Hall, University of Oxford, email: dimitrios.tsomocos@sbs.ox.ac.uk