The Wasteful 'Money Creation' Aspect of Financial Intermediation

Abstract

I present a general equilibrium model in which the financial sector employs too many productive inputs. Intermediation is similar, in some ways, to the creation of counterfeit money: a producer can increase the amount of money in his hands at some real cost, but this is socially wasteful as it only translates into higher nominal prices. In this model, producers can increase their funding by borrowing from depositors, who would otherwise be holding idle monetary reserves. This costly activity increases the money in circulation and raises the equilibrium price level, without any real return. In the simplest case, financial intermediation is a purely wasteful use of resources. However, in the presence of heterogeneous producers, the superior borrowing ability of productive agents may improve the allocation of inputs. In a dynamic general equilibrium model with heterogeneous productivities and increasing intermediation costs, I show that tight regulation of the financial system is optimal.