Inside (the) Money Machine: Modeling Liquidity, Maturity and Credit Transformations

The key function of banks in the real world is endogenously creating (inside) money. But they do so facing solvency, liquidity and maturity risks and being subject to regulatory and demand constraints. These five aspects, representing the eventual breaks on banks’ money-creation abilities, are tightly and nonlinearly interlinked. Yet, there is no tractable quantitative macro framework that models endogenous money creation while simultaneously addressing these interlinkages. In this paper we develop a tractable macro-banking model trying to fill this gap, emphasizing two key frictions: the capital adequacy constraint (generating a credit risk premium) and the central bank’s collateral base constraint (generating a liquidity risk premium). The model simulations produce conclusions, about both normal times as well as stress episodes, many of which were frequently overlooked. For instance, it shows how – within capital requirements – setting lower risk weights on secured loans may lead to an expansion of unsecured loans. It also reveals subtle interactions between capital and liquidity regulations. The model also creates a certain bridge between a money-centered view of the price level and the fiscal theory of the price level.