The liquidity effect in the Monti-Klein model

Monetary theory suggests that a rise in the interest rate of monetary policy decreases the money stock.  However, most of the empirical studies report the inverse effect, that is, the positive correlation between the interest rates and the money stock.  This is called the liquidity puzzle.  A large number of researchers tried to mitigate the puzzle by using the alternative empirical methods.  They find that, in general, the narrower definition of the money stock does not present the liquidity puzzle.  On the other hand, few theoretical studies capture the puzzle.

In this paper, we use an industrial-organization model of the banking industry to approach the liquidity puzzle.  Our main contributions are as follows.  First, the Monti-Klein model raises the liquidity puzzle, in which a tight monetary policy increases the money stock.  When banks faces a rise in the money market interest rates, they finance from an alternative instrument, i.e., deposits. Therefore, the money stock, which includes deposits, increases.

Second, we show that under a certain condition, introducing money creation into the model partly mitigates the puzzle.  Whereas banks offer borrowers deposits, the borrowers may withdraw cash from their checking accounts.  As a result, a rise in the interest rate not only increases saving deposits, but also decreases loans and checking accounts.  Hence, the liquidity puzzle is mitigated. 

Third, we present that the unconventional monetary policy in the Monti-Klein model has the similar effect.  In fact, the condition in which there is the positive relationship between the monetary policy and the money stock is the exactly the same, while the effect of the unconventional monetary policy is smaller than that of the conventional monetary policy.