Monetary Policy and Financial Market Evolution

In the 1950s and 1960s, Gurley and Shaw (1955, 1960, 1967) advanced a particular view of the joint evolution of per capita income and the financial system. They observed that at low levels of development, most investment is self-financed. As per capita income rises, bilateral borrowing and lending becomes more important. With further increases in per capita income, banks and similar financial intermediaries become prominent in financing investment. Eventually, more sophisticated financial markets, such as equity markets, arise. In the Gurley and Shaw view, rising per capita income and increasing financial depth reinforce each other. Therefore, a model of the joint evolution of per capita income and the banking system must allow usage of banks to be endogenous, and the level of per capita income and usage of banks must be determined simultaneously. Many poor countries have relatively poorly developed financial systems. Why might this be the case? One possibility is that at low levels of development, the costs of financial intermediation are too high relative to the benefits. There is ample evidence that costs of accessing the banking system are high in developing countries.1 In developing countries, penetration of the formal banking system into rural areas is limited; the high costs to the rural poor of accessing banks, such as the costs of traveling to a town with a bank branch and foregone income, are frequently cited as a reason for low utilization rates of banks. Even in the United States, about 13 percent of families do not have a checking account, and when asked why not, about half cited high service charges or other reasons related to the costs of banking.2 However, another possibility is that monetary policy also influences the choice between selffinanced and intermediated investment. Many developing countries have relatively high nominal interest rates and relatively low measures of financial depth, as measured, for example, by the ratio of M2 to gross domestic product (GDP). 3 Because the nominal interest rate represents the opportunity cost of holding currency, the relatively low rates at which banks are used in many developing countries with high nominal interest rates may seem puzzling. But banks also hold reserves of currency to provide liquidity to their depositors, and the rates of return banks offer to their depositors—the degree to which banks insure against depositors’ liquidity needs— are influenced by the nominal interest rate. Therefore, a model of the joint evolution of per capita income and the banking system must also allow monetary policy to affect the benefits of financial intermediation—rates of return on deposits and to what degree banks insure depositors against the need for liquidity. This paper considers a model in which both of these factors—the resource cost of saving through intermediaries and monetary policy, specifically the money growth rate—are important determinants of (i) whether banks are used and (ii) the level of per capita income. Our model incorporates a fixed resource cost of intermediation, similar to that in Bencivenga and Smith (1998). It also incorporates a role for monetary policy, by creating a role for government-supplied fiat money. We consider an overlapping-generations model of capital accumulation with currency as a second primary asset. Young agents can save their wage income as currency or by investing in capital formation; or young agents can deposit their saving in banks, which hold the primary assets (currency and capital investment) on behalf of their depositors. The model generates a transactions demand for