Intermediation Costs and Welfare

This paper studies quantitatively how intermediation costs affect household consumption loans and welfare. Agents face uninsurable idiosyncratic shocks to labor productivity in a production economy with costly financial intermediation and a natural borrowing limit. Reducing intermediation costs leads to two effects: First, for a given interest rate, borrowing costs decrease, which improves the ability of agents to smooth consumption overtime. Second, the demand for loans increases, which increases the interest rate. The aggregate welfare gain of reducing intermediation costs from 3.927 percent (US level) to 1 percent is about 1.14 percent of equivalent consumption in the baseline economy for an endogenous interest rate and and 1.90 for an exogenous interest rate. The gains are distributed unevenly: households at the bottom wealth decile improve welfare by 3.96 and 5.86 percent of equivalent consumption, while those at the top decile have a welfare gain of 0.35 and 0.2 percent, when the interest rate is determined endogenously and exogenously, respectively.