Money and Imperfectly Competitive Credit

By Allen Head, Timothy Kam, Sam Ng and Guangqian Pan
Published in Journal of Economic Theory

Abstract:

We develop a monetary economy in which banks have market power emanating from search frictions. Distributions of both deposit and loan interest rates are equilibrium phenomena exhibiting dispersion consistent with new micro-level evidence on U.S. consumer loans and deposits. The theory accounts for incomplete pass-through of monetary policy to the distributions of loan and deposit rates through a novel channel. Imperfect competition links monetary policy to real consumption and welfare through its effects on interest rate spreads driven by market power and individual liquidity risk. Market power in deposits erodes the insurance banks provide against liquidity risk, while market power in lending enables banks to extract surplus from goods market trades. For a given inflation target, welfare gains arise if a central bank uses state-contingent monetary injections to reduce lenders’ market power in response to fluctuations in aggregate demand.