Essays on money-issuing banks

Abstract

This thesis studies the role of commercial banks’ creation of money in influencing macroeconomic outcomes such as aggregate output, credit and employment. The principal way by which money is created in the modern economy is through the act of commercial banks granting loans. In fact, typically more than 90% of countries’ money supply consists of money issued by commercial, rather than central, banks. Yet, the role of commercial banks as creators of money is traditionally abstracted from in macroeconomic models. The fact that banks, unlike other financial institutions, can create the very money they lend is deemed to be of no great significance for the real economy, barring times of financial turbulence. This thesis aims to challenge this view by showing that commercial banks’ ability to create money can have far-reaching, and potentially problematic, macroeconomic consequences through a direct influence on the price of credit, even during financially stable times—quite simply, to matter always. The first chapter presents the main theoretical framework and starts by considering an economy with a constant stock of outside money (i.e., absent a central bank). Using a cashin-advance framework extended to allow for privately issued money, I demonstrate how commercial banks’ creation of demand-deposits which thereafter circulate as a medium of exchange can result in a persistently lower real interest rate—i.e., cheaper credit. This is due to moneycreating banks’ ability to issue more credit, and their willingness to do so at lower interest rates, compared to banks limited to intermediation of existing money units only. Though other agents must be willing to hold the privately issued money, I show that this in itself provides surprisingly little discipline. Further, the drop in the real interest rate changes firms’ production decisions and hence aggregate output, potentially lowering welfare for all. Moreover, the low price of credit creates a ”credit hungry” society, characterised by high levels of indebtedness and low levels of bank capital. Importantly, the impact via credit markets can take place even in the case of a perfectly stable stock of bank-created money. In the second chapter, I extend the analysis to an environment in which a central bank can change the stock of outside money over time. Here, I demonstrate an important interaction effect: the presence of money-creating commercial banks can give the central bank a more persistent role in influencing the real interest rate than hitherto acknowledged. Specifically, the downward pressure on the nominal interest rate stemming from commercial banks’ money creation makes it unable to adequately reflect the rate of inflation, even in the long run. Thus the steady-state real interest rate becomes a function of the central bank’s inflation target, rather than exclusively determined by agents’ rate of time preference as would be the case absent commercial banks’ creation of money. This can change the direction of monetary policy’s impact on aggregate employment and output.