Credit, banking, liquidity shortfall, and monetary policy

- This paper explores dynamic interactions among the choice of means of payment, bank's reserves, and liquidity shortfall.
- A bank can face a liquidity risk as its ex-ante reserves fall short of liquidity demand.
- In equilibrium, the likelihood of a liquidity risk increases with credit-transaction costs due to larger cash withdrawals.
- When the government increases money growth, both the demand for cash and the likelihood of a liquidity shortfall increase.

A simple monetary model is constructed to explore dynamic interactions among the choice of means of payment, bank's reserves, a liquidity shortfall, and monetary policy. In the presence of credit-transaction cost shocks, a bank that issues credit can face a liquidity shortfall as its ex-ante reserves fall short of liquidity demand. In equilibrium, credit payments and collections by a bank are balanced with each other and hence bank's ex-post reserve holdings crucially depend on the demand for cash. The likelihood of a liquidity shortfall increases with credit-transaction costs due to larger cash withdrawals. When the government increases money growth, both the demand for cash and the likelihood of a liquidity shortfall increase.