Banking and Interest Rates in Monetary Policy Analysis: A Quantitative Exploration

This paper embeds a fully-specified banking sector into a dynamic stochastic general equilibrium framework. The goal of the paper is to provide a first attempt at quantifying the effects of banking in general equilibrium, in terms of both its steadystate implications and dynamic properties. The paper provides valuable insights into the valuation of liquidity services provided by various financial instruments through its steady-state analysis and a rich exploration of dynamic model properties and policy-relevant questions through simulation exercises conducted under alternative monetary policy scenarios. In principle a general equilibrium model augmented to include a fully microfounded banking sector can provide a nice contrast to the current generation of dynamic New Keynesian (DNK) models which imply that monetary aggregates are not important for policy or welfare analysis. Although most DNKmodels ignore monetary aggregates, recently, policy institutions such as the BIS and the Bank of England have expressed concern about rapid growth of such aggregates. In addition, understanding the role of the banking sector may help explain historical episodes such as the Great Depression as well as the financial crises that swept through Asia and Scandinavia during the late 1980s and 1990s. These crises are often linked to developments in the banking sector. More generally, the bank-lending channel may be an important component of the monetary transmission mechanism. It is therefore important to develop fully fleshed-out models that include banking in general equilibrium, and I enthusiastically welcome these efforts. The model in this paper has a number of key ingredients. It specifies a transactions demand for money combined with loanable funds that are created through the banking system. The key component of the model is a lending production function that combines banking effort with collateral. The driving assumption here is that bank effort serves as a substitute for collateral for agents seeking to obtain loans. Increased banking effort is obtained through an increase in employment in the banking sector. The main contributions of the model are threefold: 1) It provides a methodology to value liquidity services provided by various assets based on their ability to serve as collateral for loans. In this regard, the calibrated model does a good job of characterizing steady-state interest rate differentials given key assumptions regarding the loan production function and the degree of substitutability between collateral and effort. 2) Model dynamics suggest that the model may either amplify or dampen the effect of exogenous shocks owing to movements in the external finance premium. There are two forces at work here. A positive shock raises collateral values and increases loan supply. Such a shock also increases deposit demand and hence the amount of banking