Insider Money as a Source of Investment Finance
Hartley, Peter R., Journal of Money, Credit & Banking
Households demand bank deposits for the liquidity services such assets provide. Higher-yielding assets usually are available to finance future consumption. Nevertheless, the demand for bank liabilities enables banks to finance investment. One might therefore expect more capital in an economy utilizing banks. We show that, when low-wealth households cannot borrow, bank lending increases the capital stock and reduces equilibrium interest rates, while making the real equilibrium more sensitive to shifts in the demand for inside money. When households can borrow, however, bank lending is absorbed by low-wealth households and banks have few effects on the real equilibrium.
In an economy in which all money is an outside asset, the equilibrium capital stock reflects the desire of consumers to save for future consumption. When inside money is used, however, the demand for a medium of exchange is harnessed by banks to finance investment. In effect, indirect claims to productive capital circulate in place of outside money. It might be thought, therefore, that an economy with inside money would support extra capital and produce more output. There may also be a presumption that changes in the demand for inside money, or the costs of intermediation, would affect the supply of bank loans and therefore the aggregate level of investment.
We present a general equilibrium model where these conjectures are substantiated, but only if households face borrowing constraints. Households with unlimited opportunities to borrow or lend would engage in intertemporal arbitrage unless the riskless real interest rate equalled the household rate of time preference.(1) The marginal product of capital, and thus equilibrium capital stock, then should remain largely unaffected by changes in the size or efficiency of the banking industry. Increased household borrowing would compensate for increased lending from banks, while a contraction in bank finance would be accompanied by disintermediation, or an increase in loans to firms from other sources.
In several interesting papers, Williamson (1987, 1988) and Bemanke and Geitler (1989) present general equilibrium models in which fluctuations in bank lending alter aggregate investment, output, and consumption.(2) Disintermediation is impossible in their model economies because banks finance all investment. Their results would also be relevant, however, to an economy in which other financial intermediaries are imperfect substitutes for banks. They argue that banks provide a unique service as a result of an asymmetry of information between lenders and borrowers. These asymmetries also determine the probability of bankruptcy for firms borrowing from banks.
This paper also discusses an intertemporal general equilibrium model with an asymmetry of information between lenders and borrowers. We assume that the resulting possibility of bankruptcy restricts some firms to bank finance. Households can, however, lend directly to some firms. Furthermore, some firms can either borrow from banks or directly from households. We also assume that bank liabilities, but not direct household loans to firms, serve as a medium of exchange.(3)
If households do not face credit constraints (limitations on borrowing against future labor income), we show that the stationary real interest rate on direct loans from households is tied to the rate of time preference. Arbitrage by firms able to choose their source of finance then ties bank interest rates to the real interest rate on direct loans. The rate of time preference becomes the key determinant of all real interest rates and therefore the marginal product of capital and the capital stock. Changes in the supply of bank loans have few long-run effects on the general equilibrium of the economy. Disintermediation, and changes in household borrowing, substantially offset any changes in the size of the banking sector.
When households cannot borrow against future income, however, the stationary equilibrium(4) real loan interest rate is below the household rate of time preference. …