THE EFFECTS ON MONETARY POLICY OF RISING COSTS IN COMMERCIAL BANKS*

Abstract

THE PURPOSE OF THIS paper is to examine the possibility that the effectiveness of monetary policy has been impeded by growing rigidities within the commercial banking system. The paper will attempt to demonstrate that these rigidities have increased during the last decade and that their development can be ascribed to the growing cost pressures in commercial banks. Since the monetary authorities can, in effect, impose their decisions on the economy only through the commercial banking system, the efficiency of banks as a means of policy transmission is of paramount importance. In recent years monetary policy has been criticized as an economic weapon incapable of achieving the degree of effectiveness that has been claimed on its behalf. Milton Friedman and others have suggested that the errors in cyclical diagnosis and the lags inherent in monetary policy between implementation and effect are such that discretionary central banking should be abandoned in favor of an automatic system of increasing the money supply at a constant rate, regardless of cyclical conditions.' J. G. Gurley and E. S. Shaw have proposed that the powers of the Federal Reserve System be widened, in order that the relative decline in the share of the financial markets commanded by the commercial banking system be offset by bringing under the control of the Federal Reserve System other types of financial intermediaries.2 The Gurley-Shaw thesis is essentially a criticism of the effectiveness of the commercial banking system as a vehicle of policy transmission because of the system's decline in importance. Commercial banks are profit-motivated institutions, and their response to central bank actions is largely influenced by the manner in which these actions affect their profit opportunities. However, if