Banking competition, production externalities, and the effects of monetary policy

Since the global financial crisis, there has been a significant amount of concern about the presence of large-scale financial intermediaries which affects the competitive landscape of the banking sector in advanced economies. In light of this issue, this paper develops a framework to demonstrate how the degree of concentration impacts economic activity. As is standard in the growth literature, we incorporate production externalities from the aggregate capital stock which promote economic development. In this setting, we show that monetary policy may need to accommodate departures from perfect competition by setting a higher rate of money growth. In fact, in the presence of large capital externalities, neither low inflation nor perfect competition may be optimal. That is, in environments where capital accumulation would be expected to be inefficiently low, the optimal rate of money growth is higher than the Friedman rule in order to encourage investment—yet, the optimal competitive structure favors increased concentration to foster a large seigniorage tax base that also adds to the capital stock.