Monetary Policy and Asset Prices: A Mechanism Design Approach Tai-Wei Hu Northwestern University Guillaume Rocheteau University of California, Irvine This version: November 2012 Abstract We investigate the e/ects of monetary policy on asset prices in economies where assets are traded in over-the-counter (OTC) markets. The trading mechanism in pairwise meetings is designed to maximize social welfare taking as given the frictions in the environment (e.g., lack of commitment and limited enforcement) and monetary policy. We show that asset price "bubbles" emerge in a constrained-e¢cient monetary equilibrium only if liquidity is abundant and the rst best is imple- mentable. In contrast, if liquidity is scarce, assets are priced at their fundamental value in any constrained-e¢cient monetary equilibrium, in which case an increase in ination has no e/ect on asset prices, but it reduces output and welfare. Finally, for low ination rates the bursting of an asset price bubble can be an optimal response to a shock that reduces assets resalability. JEL Classication: D82, D83, E40, E50 Keywords: money, liquidity, asset prices, pairwise trades, mechanism design We thank Neil Wallace, participants at the Money, Payment, and Banking workshop at the Federal Reserve Bank of Chicago, and participants at the seminar at Bank of Canada for useful comments.