Money Creation and Banks’ Interest Rate Setting

Abstract

The conventional view on banks’ interest rate-setting strategy implies that the decisions on the deposit and loan rates may be made independently. An alternative approach is based on the assumption of a bank’s predetermined liabilities structure. Such an assumption requires that the availability of deposits automatically increases (decreases) when more (fewer) loans are granted. Arguably, that they may be partially true considering that deposits are created via lending. We set up a microsimulation model and show that in certain environments it may be beneficial for large banks to incorporate information on the retail funding costs into the lending rate-setting decision.