Bank credit and money creation in a DSGE model of a small open economy

From the bookkeeping perspective, the flipside of bank loan issuance is a simultaneous creation of a deposit in the borrower’s account. By the act of lending banks do not simply intermediate pre-accumulated real resources but rather create new financial resources (money in the form of deposits) and new purchasing power. Being a major driver behind money growth, bank credit directly fuels domestic demand and inflationary pressures and thus needs to be modelled as a monetary phenomenon rather than as a mere reallocation of real resources. To this end, we develop a simple DSGE model and show that the basic DSGE framework, representing an open flexible-price economy with savers and borrowers and a simple bank with an explicit balance sheet, can indeed capture the essence of a bank as a monetary institution. The theoretical model confirms that the financial system is highly elastic in a sense that banks can extend loans at will largely irrespective of pre-accumulated resources and without needing to raise nominal deposit rates or increase financing from abroad. Moreover, in our model, changes in bank credit do have an immediate impact on nominal incomes, domestic demand and real economic activity. Model results are highly relevant from the policy perspective because they explain the fundamental relationship between financial (credit) cycle and the business cycle (e.g. observed income growth can be a consequence of a credit boom) and also suggest that sound domestic banks can stimulate domestic demand and can effectively reduce the developing economy’s reliance on foreign financing. Notably, the model focuses on a small open economy – a member of a monetary union – which thus has no independent monetary policy. We calibrate the model to the Lithuanian data and perform a number of policy-relevant shock experiments.