Money in the Equilibrium of Banking

Money is both the medium for transaction and the most liquid asset for banks. We examine both roles of money in an integrated framework, where banks are subject to aggregate illiquidity risk. An active central bank can replicate the constrained efficient allocation, which, however, cannot be implemented in the market equilibrium: due to moral hazard problems, banks invest excessively in illiquid assets, forcing the central bank to provide liquidity at low interest rates. An interest rate policy aiming to reduce systemic liquidity risk is dynamically inconsistent. Instead, the constrained efficiency can be achieved by imposing ex ante liquidity coverage requirement.