Welfare-Maximizing Inflation Rates under Fractional Reserve Banking with and without Deposit Rate Ceilings: Note

Abstract

1. lntroduction Friedman (1971), in his paper on the revenue-maximizing rate of inflation, notes three possible monetary regimes: (1) the government as sole issuer of non-interest bearing money; (2) a model with competitive banking and fractional reserve requirements; and (3) a fractional reserve system with an effective restriction on interest payments. Calvo and Fernandez ( 1983) show that maximal government revenues are not different between the first two classes, but the revenue-maximizing rate of inflation increases without bound as the reserve ratio falls. 1 Section 2 will argue that, under a deposit rate ceiling (Friedman's third case), the revenue-maximizing rate of inflation is unaltered or even lowered by fractional reserve banking, while the maximal revenues fall. Bailey (1956), Tower (1971), and several other papers have focused on the welfare-maximizing rate of inflation. Unless the marginal cost of explicit tax finance and the marginal benefit of government expenditures are infinite, a welfaremaximizing government would not pursue inflationary finance to the revenuemaximizing rate. Section 3 will extend an analysis similar to Tower's to explore the implications of fractional reserve banking with deposit ceilings. Recent banking deregulation has tended towards removing the restrictions on competitive banking. Section 4 will argue that, in a competitive banking model, the welfare-maximizing rate of inflation may rise or fall.