Abstract
The creation of liquidity is one of the key roles that banks play in the economy. Claims that bank liquidity creation is vital for economic growth date back at least to Smith (1776). This chapter focuses on the theories of liquidity creation. Modern financial intermediation theory started to formalize theories of liquidity creation in the early 1980s, and the theory is still evolving. The theories argue that banks create liquidity on and off the balance sheet. Examples are given to illustrate this. The chapter also discusses that while the theories focus on commercial banks, they could be extended to other financial institutions and markets.
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