Liquidity Constraint of Banks and Non-Neutrality of Monetary Policy

This paper studies non-neutrality of monetary policy incorporating three facts: The majority of media of exchange is not fiat money but bank liability; fiat money is largely used by banks to meet liquidity demand; and banks extensively use government bonds for liquidity management. It finds that monetary policy produces real effects by changing the tightness of banks' liquidity constraint; its effect for liquidity unconstrained banks is the opposite of that for the maximally constrained; expansion of digital ways of payment increases price levels by reducing the withdrawal probability; and if this probability becomes zero fiat money stops circulation.