Banks, Liquidity Management and Monetary Policy
134 Pages Posted: 15 Sep 2014 Last revised: 17 Sep 2014
Date Written: September 2014
We develop a tractable model of banks' liquidity management and the credit channel of monetary policy. Banks finance loans by issuing demand deposits. Loans are illiquid, and transfers of deposits across banks must be settled with reserves in a frictional over the counter market. To mitigate the risk of large withdrawals of deposits, banks hold a precautionary buffer of reserves and government bonds. We show how monetary policy affects the banking system by altering the tradeoff between profiting from lending and incurring greater liquidity risk. We consider two applications of the theory, one involving the connection between the implementation of monetary policy and pass-through to loan rates, and another considering a quantitative decomposition behind the collapse in bank lending during the 2008 financial crisis. Our analysis underscores the importance of liquidity frictions and the functioning of interbank markets for the conduct of monetary policy.
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