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Financial Intermediation, Liquidity and Inflation

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  • Jonathan Chiu
  • Cesaire Meh

Abstract

This paper develops a search-theoretic model to study the interaction between banking and monetary policy and how this interaction affects the allocation and welfare. Regarding how banking affects the welfare costs of inflation: First, we find that, with banking, inflation generates smaller welfare costs. Second, we show that, lowering inflation improves welfare not just by reducing consumption/production distortions, but also by avoiding intermediation costs. Therefore, understanding the nature of intermediation cost is critical for accurately assessing the welfare gain of lowering the inflation target. Regarding how monetary policy affects the welfare effects of banking: First, banking always improves efficiency of production, but the banking technology has to be efficient to improve welfare (especially in low inflation economy). Second, welfare effects of banking depend on monetary policy. For low inflation, banking is not active. For high inflation, banking is active and improves welfare. For moderate inflation, banking is active but reduces welfare. Owing to general equilibrium feedback, banking is supported in equilibrium even though welfare is higher without banking.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 08-49.

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Length: 49 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:bca:bocawp:08-49

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Keywords: Monetary policy framework;

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References

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  1. David Andolfatto & Ed Nosal, 2003. "A Theory of Money and Banking," Macroeconomics, EconWPA 0310003, EconWPA.
  2. Berentsen, Aleksander & Camera, Gabriele & Waller, Christopher, 2007. "Money, credit and banking," Journal of Economic Theory, Elsevier, vol. 135(1), pages 171-195, July.
  3. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 113(3), pages 463-484, June.
  4. Ping He & Lixin Huang & Randall Wright, 2005. "Money And Banking In Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 637-670, 05.
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Cited by:
  1. Aleksander Berentsen & Guido Menzio & Randall Wright, 2009. "Inflation and Unemployment in the Long Run," Kiel Working Papers 1501, Kiel Institute for the World Economy.
  2. Jonathan Chiu & Cesaire Meh & Randall Wright, 2011. "Innovation and Growth with Financial, and other, Frictions," NBER Working Papers 17512, National Bureau of Economic Research, Inc.
  3. Jagjit S. Chadha & Luisa Corrado & Sean Holly, 2013. "A Note on Money and the Conduct of Monetary Policy," CEIS Research Paper 279, Tor Vergata University, CEIS, revised 13 May 2013.
  4. Rojas Breu, Mariana, 2013. "The welfare effect of access to credit," Economics Papers from University Paris Dauphine 123456789/7353, Paris Dauphine University.
  5. Jonathan Chiu & Mei Dong & Enchuan Shao, 2012. "On the Welfare Effects of Credit Arrangements," Working Papers, Bank of Canada 12-43, Bank of Canada.

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