Introduction

The objective of this paper is to introduce banking and

credit into an essential model of money. In our framework, money
is essential as a medium of exchange but due to idiosyncratic
preference shocks some agents have excess money holdings and
others have too little.
Banks provide intermediation services by accepting
deposits and making loans. All deposits and loans are nominal as
is the interest rate paid to depositors and charged to borrowers.
Banks have a record keeping technology over its financial
histories with customers but not on trading histories amongst the
agents themselves. Consequently, the existence of banks does
not eliminate the need for money as a medium of exchange.
I will demonstrate that for any positive nominal interest rate,
banks expand the set of allocations and thus are essential. Under
the Friedman rule, banks are not essential the allocation
without banks is the same as with banks. This raises an
interesting interaction in the choice of monetary policy and the
efficiency gains arising from a banking system. I also explore how
banks amplify or dampen shocks to the real economy and the role
of stabilization policy for the central bank .
And I will demonstrate that banks transmit excess liquidity
shocks into the consumption making it more variable than would
be the case without banks.I also examine the Ramsey problem
confronting the central bank with regards to how it adjusts the
money stock within a period in response to these shocks. Our
main finding is that it is optimal for the central bank to provide an
elastic supply of currency to the market - it should inject reserves
into the banking system when demand is high and withdraw them
when demand is low.