The new monetarist framework makes it possible to draw a distinction between two types of liquidity: monetary liquidity and market liquidity. First, observe that market liquidity is the type of liquidity that is modeled in a competitive equilibrium framework. Or to be more precise, because models of competitive equilibrium are driven by market clearing which by assumption converts individual demand and supply into a price-based allocation, they give us information about the kind of liquidity that derives from the meeting of demand and supply. Not only do prices change in such market models, but it is an essential aspect of market liquidity that prices must change in response to fundamental changes in supply and demand.
Of course, money is not essential in competitive equilibrium models and the new monetarist framework grew out of the project of figuring out how to make money essential. The short version of the outcome of this project (discussed at somewhat greater length in my first post on New Monetarism and Narrow Banking) is that money is essential in models where agents buy and sell at different points in time.
As I have argued elsewhere, an implication of new monetarism is that the competitive equilibrium framework can be easily augmented to make money essential. All that is necessary is to divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability. (Note that the demand for micro-foundations meant that I was required to introduce the monetary friction in the form of assumptions regarding endowments and preferences — that as far I as am concerned simply muddy the model.)
An important advantage of introducing this simplest of monetary frictions into competitive equilibrium models is that all the implications that have ever been drawn from such models are still valid given one proviso: they must explicitly assume that the process of providing within period (or short-term) credit is perfect. In short, careful use of new monetarist methods can be used to illuminate the assumptions underlying the concepts of competitive equilibrium and market liquidity.
Monetary liquidity is then the process of addressing the within period frictions. It becomes immediately obvious in this framework that cash is an inadequate means of addressing the monetary friction, because an endogenous cash-in-advance constraint is generated. Any agent who is assigned to buy first and doesn’t hold enough cash will be liquidity constrained. In this framework, it is essential to have enforceable short-term debt contracts in order to eliminate the monetary friction and have perfect provision of monetary liquidity.
This last point is why narrow banking proposals are misguided. They misconceive of what is necessary to have perfect provision of monetary liquidity. Cash or sovereign/central bank solutions to the monetary problem generate a cash-in-advance constraint. Only a form of money that includes short-term debt can fully address the monetary friction.