Liquidity, Bank Credit and Money

The current global financial crisis has seen both substantial credit impairment and pronounced market illiquidity, undermining bank balance sheets and creating a global credit contraction. One consequence has been a dramatic shift in monetary transmission. Central banks can no longer closely control market rates of interest and have reverted to quantitative approaches to monetary policy, with expansion of base and broad money aggregates. The weakness of aggregate demand has threatened to generate an accelerating fall of prices and output (deflation) and the inabilty to counter this threat using monetary policy alone has justified a masive global fiscal stimulus; but this is not a permanent solution, it is merely shifting the problem from bank balance sheets onto public sector balance sheets.Macromonetary models lag well behind these developments. The new 'Wicksellian' consensus on monetary operations has been overthrown. In the most challenging economic conditions for 70 years, the economic authorities are flying blind. As a step towards filling this gap, this paper proposes a simple baseline model for analysing the imapct of both central bank operations on commercial bank balance sheets, credit and the money supply. This is an extension of standard models of liquidity to a macro-monetary setting in which commercial bank money finances working capital, bridging the gap between the supply of labour and the production and consumption of output. In this set up monetary policy and the role of 'lender of last resort' are closely entwined, the central banks ability to control the money supply rests on the precautionary demand for reserves from commercial banks. Extensions of the model help elucidate the curent policies of quantitative easing, suggest limits on the ability of the central bank to act as lender of last resort and help elucidate the relationship between bank capitalisation and access to funding