Academic journal article Economic Inquiry

Economies of Scale in Banking, Indeterminacy, and Monetary Policy

Academic journal article Economic Inquiry

Economies of Scale in Banking, Indeterminacy, and Monetary Policy

Article excerpt

I. INTRODUCTION

There exists a large literature devoted to real indeterminacy in monetary models under various monetary policy regimes. Whether the regime targets money growth rates as proposed by McCallum (1999), nominal interest rates as proposed by Taylor (1999), or some other endogenous variable, the literature is converging to a set of benchmark conditions for local (in)determinacy in monetary economies. (1) However, this literature generally does not consider financial intermediation in their monetary environments, and there exists evidence suggesting that this may be a severe omission. First, there is the literature on banking crises where a strategic complementarity in intermediation can deliver multiple (steady-state) equilibria. (2) Second, empirical investigations by Hughes and Mester (1998) and subsequent others find significant economies of scale (henceforth, ES) at the individual level for banks of all asset sizes. (3) Finally, models with financial intermediaries allow for deposit balances (inside money) which can substitute for currency and allow for different equilibrium dynamics than in standard monetary environments. (4) This paper addresses these issues by analyzing the effect of financial intermediaries on the (in)determinacy conditions placed on a monetary economy. The extent to which financial intermediaries impact these conditions may be important for the evaluation of monetary policies.

The analysis introduces financial intermediaries into the flexible-price monetary model of Carlstrom and Fuerst (2001) (henceforth, CF), where cash-in-advance timing allows the nominal interest rate to be interpreted as a tax (i.e., opportunity cost) on goods purchased with currency. CF show that when the monetary authority targets nominal interest rates, only an aggressive response to lagged inflation will ensure determinacy. (5) This provides a useful analytical benchmark to compare the inclusion of intermediation. In this paper, instead of the standard assumption where households lend all their capital directly to firms, households can also choose to intermediate a portion of their capital and hold interest-bearing deposits at financial intermediaries. Deposits provide an alternative medium of exchange which offset the opportunity cost of currency, but their use incurs a cost. Multiple mediums of exchange is the channel through which ES in financial intermediation can deliver indeterminacy. In particular, a natural equilibrium condition in models with multiple mediums of exchange is that the marginal cost of using each medium must be equal. The cost of currency is the nominal interest rate, while the cost of deposits is the usage cost charged by intermediaries to individual depositors. If intermediaries have decreasing marginal costs of managing deposits (i.e., ES) and pass these costs onto depositors, then the usage cost becomes a source of indeterminacy in the economy. Therefore, indeterminacy from deposit costs can potentially manifest itself as an indeterminacy in the nominal interest rate path. Because this indeterminacy distorts real decisions, this is a form of real indeterminacy.

The intuition on how ES can deliver indeterminacy is straightforward. If a single household believes that the deposit holdings of other households will decrease (increase), then her/his anticipated cost of holding deposits will increase (decrease) and she/he will hold less (more) deposits. Changes in beliefs concerning the size of the deposit market take the form of (self-fulfilling) sunspot shocks, which distort real behavior and will be welfare reducing.

The key result of the analysis is that the equilibrium indeterminacy story presented above crucially depends on the monetary policy regime and the determination of nominal interest rates. Quite naturally, indeterminacy from deposit costs can only manifest itself as an indeterminacy in the nominal interest rate path if the monetary authority allows for it. …

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