Banks' Wealth, Banks Creation of Money, and Central Banking

Banks are special in that their liabilities are widely accepted as a means of payment, thereby often needed by real sectors to obtain resources. This paper studies this interaction between the banking sector and real sectors on competitive markets and the policy response of the central bank to market inefficiency, which is determined by the aggregate wealth of banks. In the circumstance of a credit crunch, the central bank improves efficiency by allowing banks to borrow its fiat money at zero interest up to a limit. This policy bears the flavor of quantitative easing policies (QE). It produces real effects in the absence of surprises and nominal rigidity. The mechanism in which it works depends on a difference in nature between bank-created money and fiat money. Furthermore, this policy, while expanding the money supply, induces deflation under the positive productivity shock. Lastly, this paper explains when interest rate policy and capital adequacy regulation are among the optimal policies within a unified model.