Money Creation, Bank Liquidity and Non-neutrality of Monetary Policy

Abstract

This paper studies the implication of banks' money creation and liquidity management for monetary policy. When borrowing fiat money banks use a government bond as collateral, which pays a fixed stream of nominal dividend. A variation in fiat money's quantity alters its unit real value, thereby changing the real value of the bond. Under certain conditions, this change moves banks' lending rates by impacting on their liquidity constraint; therefore, fiat money is non-neutral. In general, any monetary policy, modeled as a change to the aggregate nominal portfolio of the bond and fiat money, moves bank lending rates if it alters the bond-to-fiat money ratio. Moreover, the rates of liquidity unconstrained banks move in the opposite direction to the rates of those maximally constrained. Technological changes that expand digital ways of payment generate inflationary pressures by lightening banks' liquidity burden.