A General Equilibrium Money and Banking Paradigm

Abstract

IN THIS PAPER we propose and analyze a new paradigm for monetary analysis that is considerably richer than the standard money multiplier models found in the literature. A general equilibrium approach to financial assets is developed that leads directly to a multiplier system that transcends the traditional dependence on demand deposits and is easily amenable to exposition and manipulation. The model incorporates financial innovation and regulatory changes easily and allows for the general equilibrium effects of the variation in financial ratios that result from induced movements in income, interest rates, or prices. The current analysis differs from traditional multiplier presentations in two distinct ways. First, the traditional approach to monetary expansion and multiplier analysis relies upon the ratios of various financial assets to demand deposits. Over the last decade decreased financial regulation and subsequent innovation have substantially changed the nature of depository institution liabilities and their substitutability with demand deposits. This has led to the reduction in emphasis on demand deposits per se and an increasing dependence upon transaction accounts other than demand deposits. Thrift institutions' NOW accounts, automatic transfer accounts and overdrafts, money market mutual funds, and overnight repurchase agreements have made the dependence on demand deposits as a basis for multiplier analysis somewhat obsolete and artificial. The model developed here can accommodate any number of transaction assets by specifying general asset demand ratios relative to total household wealth. The second and more fundamental way in which our model differs from existing ones is the way in which it weds general equilibrium considerations with simple multiplier analysis. The traditional approach to multipliers is to assume that any ratio between two financial assets vying for a role in the aggregate wealth portfolio is exogenous and invariant to other variables. In today's economy this seems rather inappropriate. Any regulatory or asset preference change will result in changes in the endogenous variables in the economy which will further impact financial demands. The exogeneity of asset preferences and reserve ratios is no