Real Liquidity and Banking

Abstract

Real liquidity refers to the real purchasing power of the monetary base. In an economy where banks only take money as deposits, insufficient real liquidity constrains the price level when there is a liquidity shock before banks settle their long-term loan contracts. This leads to strictly positive nominal investment return and over-investment. In the presence of systemic liquidity shocks, the price-adjustment mechanism cannot take full effect with a real liquidity shortage, which can lead to non-zero profits for banks. Quantitative easing, featuring a combination of nominal liquidity injection and lump-sum tax, can help the economy achieve a socially optimal allocation. Exchanging real goods for reserve assets to increase the real value of monetary base can improve social welfare.

Keywords: Real liquidity, Medium of Payment, Liquidity Shortage, Bank Efficiency, Quantitative Easing

JEL Classification: E40, E50, G20