Abstract
We study today’s two-tier money creation and destruction system: Commercial banks create bank deposits (privately created money) through loans to firms or asset purchases from the private sector. Bank deposits are destroyed when households buy bank equity or when firms repay loans. Central banks create electronic central bank money (publicly created money or reserves) through loans to commercial banks. In a simple general equilibrium setting, we show that symmetric equilibria yield the first-best level of money creation and lending when prices are flexible, regardless of monetary policy and capital regulation. When prices are rigid, we identify the circumstances in which money creation is excessive or breaks down and the ones in which an adequate combination of monetary policy and capital regulation can restore efficiency. Finally, we provide a series of extensions and generalizations of the results.
Highlights
1.1 Motivation and approachMoney is predominantly held by the public in the form of bank deposit contracts.1 These deposits—which are claims on banknotes—are typically created by the banks’ lending decisions
We focus on how price rigidities and the zero lower bound affect the interplay of competitive issuance of private money by banks and public money by the central bank, and our focus is quite different from the above-mentioned literature
If the real interest rate is positive in one state of the world, a judicious combination of monetary policy and capital requirements leads to second-best allocations in the sense that banks are active in equilibrium, but the amount of investment goods channeled to sector MT is inefficient
Summary
Money is predominantly held by the public in the form of bank deposit contracts. These deposits—which are claims on banknotes—are typically created by the banks’ lending decisions. Money is predominantly held by the public in the form of bank deposit contracts.1 These deposits—which are claims on banknotes—are typically created by the banks’ lending decisions. We build the simplest general equilibrium model for which the feature that competitive commercial banks create money by granting loans is crucial. In this setting, we investigate the functioning of money creation in various circumstances and we examine which combinations of central bank policy rates and capital requirements lead to a socially efficient money creation and intermediation of households’ endowments to the production sectors. Money in the form of bank deposits is destroyed when firms repay their loans, and money in the form of central bank reserves is destroyed when banks repay their central bank liabilities
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