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Financial Intermediation, Liquidity and Inflation

Author

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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.

Suggested Citation

  • Jonathan Chiu & Cesaire Meh, 2008. "Financial Intermediation, Liquidity and Inflation," Staff Working Papers 08-49, Bank of Canada.
  • Handle: RePEc:bca:bocawp:08-49
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    References listed on IDEAS

    as
    1. Berentsen, Aleksander & Camera, Gabriele & Waller, Christopher, 2007. "Money, credit and banking," Journal of Economic Theory, Elsevier, vol. 135(1), pages 171-195, July.
    2. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
    3. David Andolfatto & Ed Nosal, 2003. "A theory of money and banking," Working Paper 0310, Federal Reserve Bank of Cleveland.
    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, May.
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    Citations

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    Cited by:

    1. Chadha, Jagjit S. & Corrado, Luisa & Holly, Sean, 2014. "A Note On Money And The Conduct Of Monetary Policy," Macroeconomic Dynamics, Cambridge University Press, vol. 18(08), pages 1854-1883, December.
    2. Jonathan Chiu & Cesaire Meh & Randall Wright, 2017. "Innovation And Growth With Financial, And Other, Frictions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 58, pages 95-125, February.
    3. Rafael Silveira & Randall Wright, 2016. "Venture Capital: A Model of Search and Bargaining," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 19, pages 232-246, January.
    4. repec:dau:papers:123456789/7353 is not listed on IDEAS
    5. Valencia, Fabián, 2014. "Banks' Precautionary Capital And Credit Crunches," Macroeconomic Dynamics, Cambridge University Press, vol. 18(08), pages 1726-1750, December.
    6. Jonathan Chiu & Mei Dong & Enchuan Shao, 2012. "On the Welfare Effects of Credit Arrangements," Staff Working Papers 12-43, Bank of Canada.
    7. repec:eee:dyncon:v:89:y:2018:i:c:p:100-116 is not listed on IDEAS
    8. Guillaume Rocheteau & Randall Wright & Cathy Zhang, 2018. "Corporate Finance and Monetary Policy," American Economic Review, American Economic Association, vol. 108(4-5), pages 1147-1186, April.
    9. Aleksander Berentsen & Guido Menzio & Randall Wright, 2011. "Inflation and Unemployment in the Long Run," American Economic Review, American Economic Association, vol. 101(1), pages 371-398, February.

    More about this item

    Keywords

    Monetary policy framework;

    JEL classification:

    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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