Banks as dealers of credit money: Comparing the roles of banks and non-banks in the provision of liquidity

Using a general equilibrium monetary model for banks, we analyze the role of banks in providing liquidity to the financial market and the transmission of the financial liquidity channel of monetary policy. In the model, the roles of banks in the payment system give banks additional abilities to provide liquidity. Because bank deposits can be used as means of payment, banks can directly create and lend new deposits that are not backed by money collected from depositors. As a result, the private banking system has the ability to supply loans elastically to meet the stochastic liquidity needs of the economy with very little need to borrow from the central bank. We show that the existence of banks is important to non-banks. When aggregate liquidity is limited, the attempt of non-bank investment funds to provide more liquidity insurance to shareholders may lead to higher volatility in asset prices without actually giving more liquidity to shareholders. New inside money provided by banks can reduce the volatility of asset prices and help non-banks perform their risk-sharing functions more effectively. We also show how the interest rate policy can be transmitted to asset prices by affecting the liquidity constraint of banks.