Monetary Policy and Financial Intermediation

By Fuerst, Timothy S. | Journal of Money, Credit & Banking, August 1994 | Go to article overview

Monetary Policy and Financial Intermediation


Fuerst, Timothy S., Journal of Money, Credit & Banking


Throughout much of the 1980s, the real business cycle literature crowded out research on equilibrium models of the monetary transmission mechanism. Recently work on this latter topic has been spurred by new evidence that monetary policy may affect real activity.(1) There are many possible explanations for why money matters. This paper explores a reason based on reserve requirements. In particular, suppose that financial intermediaries offer deposit accounts that are subject to reserve requirements, and use these accounts as a source of loanable funds. Also, suppose central bank monetary injections occur within the financial intermediary system, and are not initially subject to these reserve requirements. This asymmetry will make it impossible for all nominal quantities to increase by x percent, when the money supply grows by x percent. Hence, monetary injections will be non-neutral. In particular, injections will stimulate the lending behavior of financial intermediaries.

Why do intermediaries exist? The Modigliani-Miller theorem implies that the answer to this question is nontrivial. Potential answers have been provided in recent equilibrium models of Boyd and Prescott (1986), Diamond (1984), and Williamson (1986).(2) The common thread in these models is that there exists a degree of private information about entrepreneurial projects that effectively closes credit markets that directly link borrowers and lenders. In these environments there is a natural role for institutions that specialize in the evaluation of risky projects and the enforcement of loan contracts. These institutions are called intermediaries. Instead of directly modeling the information structure that will produce intermediaries, this paper simply assumes that all loans must occur through them. The goal of this paper is to analyze the effect of monetary injections on this intermediation process.

To be precise, this paper presents a model economy in which money is valued because of cash-in-advance constraint on consumption purchases and a legal restriction on intermediation. Intermediaries are assumed to face a reserve requirement: currency reserves must be greater than or equal to a certain fraction of the deposits they accept. This is a natural cash constraint that all intermediaries face. The model economy is populated by households and firms, the former with resources that they would like to lend to the latter. Since these loans must occur through intermediaries, the reserve requirement is a tax on this intermediation process. Injections of new currency directly to the intermediaries temporarily avoid this tax. Monetary injections can thus be seen as temporary reductions in the tax on intermediation, and therefore temporarily stimulate real activity. The model also gives rise to an endogenous money multiplier because some purchases are made with cash, while others with checking accounts, and the cash versus check composition of total purchases varies with the aggregate shocks.

The paper proceeds as follows. Section 1 presents the basic model. The deterministic version of the model is discussed in section 2. This sets the stage for section 3 in which the stochastic case is analyzed. Section 4 concludes the paper.

1. THE MODEL

The economy consists of three classes of agents: households, firms, and banks. There are numerous economic agents within each class, so that all behave as atomistic competitors. Given this assumption, I will confine the analysis to a representative household, firm, and bank. I will explain the behavior of each agent in turn.

The representative household is infinitely lived and has preferences over consumption streams given by

[Mathematical Expression Omitted]

where [beta] [element of] (0, 1), U(c) = log(c), [c.sub.t] is time t consumption of the single perishable good, and the expectation is over realizations of the economy-wide shocks. Random variables will be denoted as functions mapping the compact state space S [subset] R into the appropriate range. …

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