Procyclical Finance: The Money View

Abstract

Banks are important because firms hold their debt ("inside money") as liquidity buffer. Banking crises are costly because the contraction of inside money supply compromises firms' liquidity management and hurts investment. By highlighting the interaction between banks and firms in the money market, this paper offers a theory of procyclical inside money creation and the resulting instability. It sheds light on the cyclicality of bank leverage, and how it affects the frequency and duration of banking crises. Introducing outside money (government debt) to alleviate liquidity shortage can be counterproductive, because its competition with inside money destabilizes the banking sector.

Keywords: Inside money, liquidity management, procyclical leverage, government debt, slow recovery, intertemporal feedback

JEL Classification: E02, E22, E32, E41, E43, E44, E51, E58, E61, E62, G01, G12, G18, G20, G30