Abstract

We consider asset pricing in a monetary economy where liquid assets are held to lower transaction costs. The ensuing model extends the CAPM and the Consumption CAPM by deriving real money growth as an additional factor determining returns. Empirically, the unconditional version of this model compares favorably to other theoretical asset pricing models. Allowing for conditional variation in factor sensitivities improves model performance so the model performs as well as the a-theoretical Fama-French three factor model. The paper further introduces a technique that facilitates derivation of dynamic asset pricing results in discrete time by generalizing Stein’s Lemma to multivariate cases.