On A Pecuniary Externality of Competitive Banking Through Goods Pricing Dispersion

By Timothy KAM, Hyungsuk LEE, Junsang LEE and Sam Ng
Published in European Economic Review

Abstract:

We study the interaction between banking, endogenous market power with price dispersion in goods markets, and reserve requirement regulation. If the reserve requirement never binds, then the economy is a banking generalization of Head et al. (2012): the addition of banking has no pecuniary externality on goods trades and banking is always welfare improving. If the reserve requirement binds, there is a positive spread between lending and deposit rates. In this empirically-relevant case, there is a pecuniary externality: banking amplifies retail-goods firms’ market power. Credit- and policy-dependent heterogeneity in retail-good markups implies a non-monotonicity in the welfare-improving role of banks. We explain the novel opposing forces at work. Our model also justifies why policymakers should be worried about the nexus between inflation, banking and industry markups.