title: Money Creation by Banks, Regulation and Optimal long-run Inflation Targets
Creators: name: Wipf, Christian
Publisher: name: Universität Bern
Year: 2021
Subjects: subject: 330 Economics

description: The three chapters of the dissertation cover three distinct topics in monetary macroeconomics and banking. In chapter 2 I study the welfare implications of money creation by commercial banks and of proposals to limit or prohibit this ability. chapter 3 is about the optimal long-run inflation targets of central banks and chapter 4 treats the optimal financing structure of different bank assets like business loans, mortgages or securities. In the following I briefly outline the motivation and the content of the three chapters.

Chapter 2, "Should Banks Create Money?" treats the role of commercial banks in the money supply of an economy. Currently central banks issue cash and reserves and commercial banks issue demand deposits which are claims on central bank money. Typically banks operate under a fractional reserve banking system: they issue demand deposits in excess of the central bank money they hold against redemptions. This system has been consistently criticized, especially after financial crises (1929, 2007/8). Opponents essentially argue that fractional reserve banking (money creation by commercial banks) makes the economy less stable and has no social benefits. As a consequence they want to limit or prohibit this ability of banks with so called "Narrow Banking" proposals. Narrow banks must fully back the money they issue with central bank money and thus the central bank perfectly controls the money supply. An example for a narrow banking proposal is the "Vollgeld" initiative in Switzerland rejected by Swiss voters in June 2018.

In chapter 2 I analyze the welfare implications of such proposals. Abstracting from fragility issues I show that fractional reserve banking (money creation by commercial banks) can be preferable to narrow banking. Under fractional reserve banking the lending of banks is less constrained than in a narrow banking system. More loans increase the return on bank assets and competition forces banks to pass this return to the holders of demand deposits in the form of higher interest payments. In an environment with inflation this is beneficial because inflation acts like a tax on real activity. Fractional reserve banking is beneficial compared to narrow banking because it partially compensates the agents against this "inflation tax" through higher interest payments on demand deposits.

Chapter 3, "Liquidity, the Mundell-Tobin Effect and the Friedman Rule" (co-authored with Lukas Altermatt), was motivated by the mismatch between theory and practice when it comes to optimal long-run inflation targets. Most monetary macro models find a long-run inflation rate to be optimal where the opportunity costs of holding money are zero (the so called "Friedman rule" after Friedman [1969]) which typically implies a deflationary inflation target. In practice however, no central bank runs the Friedman rule. Actual long-run inflation targets in advanced economies are around 2%. In the paper we want to reconcile theory and practice by providing a theoretical justification for long-run inflation targets above the Friedman rule.

The argument we explore is based on the so called "Mundell-Tobin effect". Mundell [1963] and Tobin [1965] argued that money and capital are to some extent substitutes as a store of value and thus changes in inflation can influence investment. For example if the rate of return of money goes down (inflation goes up) agents substitute away from money into capital, i.e. they invest more. Thus at the Friedman rule, where holding money is costless and we have deflation, agents hold more money and invest less than at higher inflation rates. Could it be that agents hold too much money and too little capital at the Friedman rule and thus a higher inflation rate would increase capital investment and welfare? In a model with a fundamental liauidity-return trade-off between money and capital, i.e. capital has a higher return but money is more liquid, we show that indeed, the optimal long-run inflation rate and the Mundell-Tobin effect are related: When there is a Mundell-Tobin effect an inflation rate above the Friedman rule is optimal and without the Mundell-Tobin effect the Friedman rule is optimal. Thus the Mundell-Tobin effect could be a justification for optimal long-run inflation targets above the Friedman rule.

Chapter 4, "Optimal Bank Financing with Less Opaque Assets" (co-authored with Kumar Rishabh), was motivated by the recent shift in bank loan portfolios from business loans towards mortgages in advanced economies (Jordà et al. [2016]). For example more than 80% of bank loans in Switzerland currently are mortgages. But mortgages and business loans seem to be quite different assets. One essential difference seems to be the ease with which these two assets can be valued by the bank (and by the investors of a bank). The value of a mortgage, which is backed by real estate, mostly depends on publicly observable factors like interest rates or the location of the building and is therefore relatively easy to value. The value of a business loans however, which is mostly backed by the value of a small or medium-sized, unlisted firm, depends more on factors only observable by the firm like the human capital of the entrepreneurs. This makes them more difficult to value for outsiders. This difference is e.g. apparent in the fact that for mortgages there is platform lending and a secondary market while both is not true for business loans. Mortgages are therefore said to be less "opaque" in the language of banking theory.

In chapter 4 we ask the question whether it is useful to finance less opaque assets like mortgages with demandable liabilities (demand deposits) as banks do. In a theoretical model we show the answer is probably no. While demandable liabilities are optimal to finance opaque assets like business loans (in line with the literature on the disciplining role of demandable debt like Calomiris and Kahn [1991]), less opaque assets like mortgages or securities should be financed with non-demandable liabilities like long-term debt or equity. In line with this theory we document a weak positive correlation between opaque assets (business loans) and a suitable measure for demandable liabilities for small and medium sized banks (up to the 75th percentile) using US bank level balance sheet data from 1992 to 2018. But we find no correlation for bigger banks. The reason could be that big banks might enjoy an implicit insurance e.g. in the form of too-big-to-fail guarantees which distorts the choice of their asset and liability structure.