THE EFFECT OF DEPOSIT RATE CEILINGS ON AGGREGATE INCOME

Abstract

CEILINGS on commercial bank deposits were first imposed in the thirties. Their announced purpose was to help assure the viability of the banking system by reducing competition. It was argued that banks would be less likely to reach for risky loans if they did not face competitive pressure from the cost of their deposits. More recently this argument has been in disfavor. Instead, deposit ceilings seem sometimes to be considered as a tool of monetary policy. However, little agreement seems to exist as to their effect at the aggregate level. Current theory leaves as an empirical question whether raising ceilings when they are effective is expansionary or contractionary. No convincing empirical evidence exists as to which is the case. The theory of the effect of deposit ceilings on GNP is based on the work of James Tobin and William Brainard [8]. They pointed out that the effect of an increase in deposit ceilings is ambiguous as a proposition in comparative statics. Other things equal, a rise in time deposit rates may either increase or decrease the demand for outside money (i.e., currency plus reserves). The demand for currency and demand deposits will fall while the demand for time deposits will increase. The net effect depends on the magnitude of these elasticities as well as the magnitude of the reserve requirements on demand and time deposits. If a rise in time deposit rates produces a net increase in the demand for outside money, the effect of a rise in time deposit ceilings is contractionary. The rate of interest on market securities must rise in order to reduce the demand for outside money and reestablish equilibrium. Conversely, if a rise in time deposit rates produces a net decrease in the demand for outside money, the effect of an increase in time deposit ceilings is expansionary. Tobin and Brainard made no effort to determine which of these cases held for the U.S. economy. In fact, their model was poorly specified for empirical implementation. For instance, it did not contain a product market sector. Recently several papers in a volume edited by Karl Brunner have extended the Tobin-Brainard results: Gramley and Chase [6], Brunner [3], and Hendershott [7]. In particular Brunner and Hendershott add a product market sector to the Tobin-Brainard model. They also attempt to determine whether raising deposit ceilings is expansionary or contractionary using elasticity estimates from various empirical studies of the demand for financial assets. Unfortunately, these estimates do not allow this question to be resolved.