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In October 2008, the Federal Reserve shifted from a federal-funds-rate target and zero interest on bank reserves to a regime with an identical interest rate on required and excess reserves, set above its targeted federal funds rate. The move established at least two possible regimes of bank behavior. This paper examines the effect of Fed payment of different interest rates on required and excess reserves. It also sketches how the corresponding model of bank behavior can be extended to allow for interbank borrowing and lending along with market-clearing in the interbank loan market. The Fed’s regime shift to banks holding positive excess reserves and minimal interbank lending strengthens the effect on bank credit of its current primary policy instrument, the interest rate on excess reserves, relative to the effect of its previous primary instrument, the federal funds rate. This regime also mitigates impacts of deposit supply shocks on bank credit volatility while boosting the impacts of loan demand shocks. Although the Fed’s payment of interest on required and excess reserves might be rationalized by a shift in the relative source of financial shocks, little basis exists for paying the same interest rate on both types of reserves. Indeed, if the Fed were to retain the post-October 2008 regime, different rates on excess reserves and required reserves could be set to reduce Fed interest payments to banks without compromising the effectiveness of monetary policy.

This paper investigates the effects of reductions in the Federal Reserve’s asset portfolio on bank lending in the context of the Dutkowsky-VanHoose model of interest on reserves and regime shifts. Based upon relative magnitudes of structural resource cost parameters, we argue that retail lending becomes considerably less responsive to exogenous monetary base changes in the post-October 2008 regime of positive excess reserves and virtually zero wholesale lending. The model provides an explanation for the observed relationship between retail loans and the monetary base before and after October 2008. Our analysis indicates that the Fed can unwind its balance sheet with minimal disruption in retail lending, as long as it continues settings of the federal funds rate and the interest rate on reserves so that banks operate in the post-October 2008 regime. However, unwinding while returning to the pre-October 2008 regime of zero excess reserves and positive wholesale loans could lead to more adverse effects on retail lending.

This paper demonstrates that in the post-2008 environment with interest on reserves, monetary policy actions can generate regime shifts that yield quantitatively and even qualitatively different responses of bank balance-sheet configurations and loan and deposit market outcomes to exogenous changes. In contrast to the view that a one-time structural change occurred in 2008, switching between several different regimes plausibly can arise depending upon settings of the reserve ratio, federal funds rate, and the interest rate on reserves. Our results explain stylized facts regarding excess reserves and interbank lending. Analysis with calibrated values indicates that such regime switching has occurred.

Even though non-interest expenses on physical capital and labor comprise at least 40 percent of banks’ total costs, much of the banking literature entirely ignores real resource costs. This paper shows that whenever banks realize economies of scope in the use of resources, banks’ balance-sheet choices are inextricably linked to their decisions regarding employment of capital and labor and demonstrates that the intensity of capital utilization must be systematically related to the loan-deposit ratio. Based on U.S. banking data, we provide empirical evidence supporting this prediction.

This paper analyzes a model in which there is excessive bank lending and in which regulators attempt to correct the problem with a tax. A tax on lending can correct the over†lending problem by reducing the returns from lending. Imposition of the tax has a perverse effect on the composition of lending, however, because it falls more heavily on banks that incur expenses to reduce loan losses. Hence, along the external margin, the share of banks that voluntarily monitor loans decreases. In contrast, monetary policy tightening can produce the optimal level of lending without generating any distortion of monitoring incentives.

Since the latter part of 2018, the federal funds rate has been equal to or nearly equal to the interest rate on excess reserves (IOER). Correspondingly, the Fed has expressed a desire for increased interbank lending within its target range for the federal funds rate. This paper examines these developments within a model of bank behavior. We argue that the resulting spread between the federal funds rate and IOER during this time led banks to switch to a third regime, different from the zero-excess-reserves regime of pre-October 2008 or the zero-wholesale-loan regime of post-October 2008 up to the period described above. Comparative-statics results from general-equilibrium solutions show that within this third regime, in which banks choose positive quantities of excess reserves and wholesale loans, banks exhibit the strongest response in retail lending to changes in the federal funds rate and the IOER. This regime, though, also has the weakest response in retail lending to a quantitative easing-type policy. Extending the model to the interbank loan market reveals that in the interior solution regime, even when faced with large increases in exogenous loan demand, banks borrow from the interbank loan market only under restrictive conditions. Taken with previous findings, we argue that monetary policy can include the Fed choosing the federal funds rate-IOER spread to determine the regime within which it desires for banks to operate. In this regard, we offer a sketch of how the Fed can utilize monetary policy strategically to stabilize the macroeconomy during the next recession.

We analyze the interaction among market competition, capital regulation, fixed regulatory compliance costs, and the portfolio and monitoring decisions of banks. We examine how the interplay among the effects of changes in the degree of competition and capital requirements regulation influence optimal bank choices and market outcomes. Furthermore, we evaluate how ratcheting up the Basel regulatory regime is likely to influence both the competitive structure of banking markets and the overall quality of bank loans. Higher capital requirements and increased fixed costs reduce the degree of competition in banking markets. The weight of these changes can fall more heavily on banks that choose to expend resources to monitor their loans to address loan losses.

This paper examines issues associated with the design and implementcation of regulatory policymaking in interconnected financial markets. The paper explains why international interdependence among nations’ financial markets and regulations can provide an incentive for national financial supervisory agencies to contemplate coordinating their regulatory policies. It also assesses, in the context of a review of recent research on the part of banking and financial economists, ways in which interdependence among financial systems can create a potential for international regulatory policy conflicts. In addition, the paper evaluates whether such conflicts are insurmountable or might be somewhat mitigated at least somewhat via bargains among regulatory authorities.

This paper examines the empirical implications of an international-trade-based view of the determination of banks’ net export positions in the provision of lending and deposit services. This trade-based perspective on international banking emphasizes the importance of banks’ expenses on labor and physical capital resources. Consequently, the theory indicates that relative abundances and intensities of these resources should play fundamental roles in influencing trade patterns in international bank loan and deposit markets. The paper focuses on the theory’s implication that systematic relationships should exist between measured overall capital intensities of nations’ banking systems and their net exports and imports of loans and deposits. Analysis of 2001–2012 data from 27 countries generally verifies the relationships predicted by the theory.

This special issue, “Banking in Macroeconomic Theory and Policy,” explores a problem that has occupied to varying degrees several recent generations of economists: identifying and integrating the appropriate role of a banking sector within a policy-relevant analytical framework of macroeconomic analysis. This introductory article tries to provide a context for the fascinating contributions to this issue. It reviews efforts to apply developments in bank modeling to augmenting macroeconomic models during the 1960s through 1980s, theoretical and empirical elements that led to diminished emphasis on incorporating banking into analytical macroeconomic frameworks between the 1990s and the 2007–2009 financial crisis, and recently renewed work to integrate banking sectors into modern macroeconomic models. The paper concludes by reviewing briefly the contributions contained in this special issue.

During the past two decades, a growing body of research has explored the implications of increased trade and financial openness for the relationship between output and inflation. This paper reviews proposed theoretical channels through which the degree of openness might ultimately affect the output-inflation trade-off and surveys the empirical studies that have sought to determine the net effect of greater openness on this trade-off. In addition, the paper utilizes a single cross-country data set to evaluate, taking into account recent developments in the literature, the likely sign and significance of this net effect. In particular, we find current data imply that there is a negative and significant relationship between openness and the sacrifice ratio, regardless of the transmission channel that is proposed.

This paper examines the joint determination of the interest rate on demand deposits and swept funds given interest on reserves and the elimination of Regulation Q. Our model works within monopolistically competitive loan and deposit markets and incorporates sweeping from deposit accounts to reserve-exempt accounts. Under unregulated deposit rates, we derive solutions for the market equilibrium values of the deposit rate and the share of deposits allocated to swept funds. Sweeping responds positively to the interbank loan rate and marginal resource costs for unswept funds, and negatively to the interest rate on reserves, reserve ratio, and the marginal resource cost of sweeping. The deposit rate responds positively to the interbank loan rate, interest rate on reserves, and reserve ratio, but negatively to marginal resource costs of sweeping and holding unswept funds. We also investigate deposit market equilibrium under a zero deposit rate restriction with sweeping. Here, the share of swept funds and the portion of the interbank rate passed on to swept balances adjust to attain market equilibrium. Sweeping enables banks to replicate outcomes from unhindered deposit rate competition. The equilibrium return that banks pay depositors and the share of swept funds are the same as with unrestricted deposit rates.

This study utilizes a dominant-bank model to investigate whether an increase in retail loan and deposit-market concentration increases the incentives for both dominant and fringe banks to monitor their loans and thereby improve the quality of their loan portfolios. It shows that the effects on banks' incentives to engage in monitoring aimed at eliminating loan default losses in response to increased concentration of retail market shares of loans and deposits depend critically on whether the banks' asset and liability choices are interdependent. When the asset and liability decisions of both dominant and fringe banks are independent, a shift in market shares in favor of the dominant bank generates a straightforward increase in the incentives of all banks to monitor their loans. Under portfolio interdependence, the effects on monitoring outcomes at dominant banks and at banks within the competitive fringe depend on more complicated configurations of parameters. This fact helps explain mixed empirical evidence on the relationships between bank competition and measures of bank risk and soundness.

This paper develops a framework for analyzing socially and privately optimal bank loan-monitoring decisions, with and without capital regulation. In contrast to the monitoring decision of a social planner who seeks to maximize the utility of aggregate consumption, banks choose to monitor only if doing so is consistent with maximizing the market value of equity. As a consequence, socially and privately optimal monitoring choices can diverge. Under some circumstances, appropriately configured capital regulation can bring private loan-monitoring decisions into line with those of the social planner. Nevertheless, the capital ratio required to attain this outcome hinges on a number of factors that are likely to be economy-specific, including the banking system's monitoring technology and its exposure to default. Thus, it is unlikely that a unique capital ratio will be able to induce socially optimal monitoring in all economies.

This paper combines essential elements of the theory of intra-industry international trade with an imperfect-competition banking framework to develop a model of intra-industry international trade in banking services. The model yields the prediction that if, for instance, the production of lending services is labor intensive while the provision of deposit services is physical-capital-intensive, banks located in a foreign nation with a relatively larger labor endowment will export lending services while banks based in a domestic country with a relatively larger endowment of physical capital will export deposit services. These efficiency-based trade flows indicate that domestic borrowers and savers will be net recipients of credit and deposits, respectively, with foreign banks obtaining funds that permit them to act as net lenders to the domestic nation by borrowing from domestic banks in a global wholesale interbank funds market. A key implication of the model, therefore, is that attainment of profit-maximizing intra-industry flows of banking-service trade requires the smooth functioning of this interbank market.

We employ industry data to examine price stickiness of durables versus non-durables to evaluate Barsky et al. (2007) proposal that stickiness of durables’ prices influences aggregate dynamics. Policy impacts from impulse responses accord with sticky-price frameworks even though non-durables’ prices are relatively flexible.

This paper investigates the relationship between firm mark-ups and inflation. In sectors of the economy with industries characterized by flexible prices and sticky wages, mark-ups should respond positively to inflation. Industry mark-ups in sectors with both flexible prices and flexible wages theoretically may rise or fall in response to an increase in the price level. Mark-ups of industries in sectors of the economy in which prices are sticky should respond negatively to inflation, with an absolutely larger negative response occurring in sticky-price industries with flexible wages. Empirical analysis of US industries provides support for nearly all of these theoretical predictions.

This article investigates how search costs, price stickiness and product durability influence the impact of inflation on firm markups. We provide evidence that each of these three factors plays an independent role in influencing the responsiveness of markups to inflation. Although we find that the direct effect of inflation on markups is negative, offsetting positive influences of inflation on markups arise in industries that produce durable experience goods with flexible prices. Thus, our results indicate that markups of industries producing nondurable search goods with sticky prices tend to experience unambiguously negative impacts from inflation.

In an important and highly influential paper [Gali, J., Gertler, M., 1999. Inflation dynamics: A structural econometric analysis. Journal of Monetary Economics 44, 195–222] develop and estimate a structural new Keynesian Phillips curve model of inflation dynamics based on the [Calvo, Guillermo, 1983. Staggered prices in a utility maximizing framework. Journal of Monetary Economics 12, 383–398] model of sticky prices. To estimate their model, Gali and Gertler measure inflation as the quarterly percentage change in the GDP deflator, and they consider a specific calculation of the deviation of labor-income share from its mean value as the only proxy measure of aggregate marginal cost. Most other researchers have followed their lead. In this paper, we closely replicate Gali and Gertler’s results and compare these replicated results to those obtained when alternative measures of marginal cost and inflation are utilized. We find that estimations of the structural new Keynesian model of inflation dynamics are not particularly altered by using a marginal-cost measure based on actual industry costs but are sensitive to using a PPI-inflation measure that arguably is more appropriate for testing a theory of firm pricing. Furthermore, we find that utilizing a detrended measure of marginal cost yields results that are at least as plausible as those of Gali and Gertler, yet which generally suggest greater aggregate US price flexibility.

The standard time-inconsistency-based explanation for the negative correlation between openness and inflation requires an inverse relationship between the sacrifice ratio and openness, but Daniels et al. (2005, Openness, central bank independence, and the sacrifice ratio. Journal of Money, Credit, and Banking 37 (2), 371–379.) have provided evidence that controlling for central bank independence reveals a positive relationship. This paper embeds the time-inconsistency approach within a model of a multisector, imperfectly competitive, open economy. In this setting, greater openness raises the sacrifice ratio but reduces the inflation bias. Thus, failure to observe an inverse relationship between openness and the sacrifice ratio does not necessarily imply that the time-inconsistency approach is irrelevant to understanding the openness–inflation relationship.

This paper develops a model of an open economy containing both sectors in which wages are market-determined and sectors with wage-setting arrangements. A portion of the latter group of sectors coordinate their wages, taking into account that their collective actions influence the equilibrium inflation outcome in an environment in which the central bank engages in discretionary monetary policymaking. Key predictions forthcoming from this model are (1) increased centralization of wage setting initially causes inflation to increase at low degrees of wage centralization but then, as wage centralization increases, results in an inflation drop-off; (2) a greater degree of centralized wage setting reduces the inflation-restraining effect of greater central bank independence; and (3) increased openness is more likely to reduce inflation in nations with less centralized wage bargaining. Analysis of data for seventeen nations for the period 1970–1999 provides generally robust empirical support for all three of these predictions.

This paper uses a three-region framework to examine the effects of European currency unification on EMU and US inflation rates. It considers ways in which increased participation in the EMU might influence inflation choices in Europe and the United States. It also considers how alternative monetary policies and parameter values might influence the extent of participation in the EMU. Copyright 2007 , Oxford University Press.

This paper develops a banking-sector framework with heterogeneous loan monitoring costs. Banks are exposed to the moral hazard behavior of borrowers and endogenously choose whether to monitor their loans to eliminate this exposure. After analyzing an unregulated banking system, we examine several cases in which regulatory capital requirements bind the notional loan supplies of various subsets of banks. To gauge the impact of capital requirements, we define loan ‘quality’ in terms of either the ratio of monitored to total loans or the ratio of monitoring banks to total bank population. Under the assumption of a specific cross-sectional distribution of banks, our simulations show that the imposition of binding capital requirements on a previously unregulated banking system unambiguously increases the market loan rate and reduces aggregate lending, but has an ambiguous effect on loan ‘quality’. Nevertheless, once capital requirements are in place, the simulations indicate that regulators can contribute to higher overall loan ‘quality’ by toughening capital requirements.

Traditional explanations of the negative correlation between openness and inflation presume that an inverse relationship between the degree of openness and the sacrifice ratio reduces the inflation bias of descretionary monetary policy. Temple (2002) concludes, however, that such a relationship fails to emerge in cross-country data. Our analysis of the same cross-country data considered by Temple indicates that once the degree of central bank independence and its interaction with greater openness and the sacrifice ratio. In addition, increased openness lessens the positive effect of central bank independence on the sacrifice ratio.

Even though macroeconomic theories developed since the late 1980s have de-emphasized the role of monetary aggregates in the transmission of monetary policy, considerable research on the demand for money has continued. This paper addresses why understanding the demand for money remains relevant, and it surveys additions to the money demand literature since the 1980s. The paper considers recent contributions to the theory of the demand for money, discusses recent econometric advances in money demand estimation techniques, and reviews evidence revealed by empirical studies of the demand for alternative monetary aggregates. We conclude by discussing avenues for future research.

Within only a few years, the new open economy macroeconomics (NOEM) has emerged as a potential rival to the Mundell-Fleming framework, as modified by Dornbusch and others in the 1980s and 1990s using linear-quadratic models, as the dominant analytical framework in the study of open economies. This paper reviews some of the main developments in this literature. It offers a critical appraisal of its contributions to date and discusses potential pitfalls of taking a pure NOEM approach by dismissing work not based in explicit utility maximization as “ad hoc.” The paper proposes broadening the NOEM literature to include consideration of heterogeneities within and across open economies. In light of the complexities involved in modeling heterogeneous agents or structures, the field of open economy macroeconomics may stand to gain from the pursuit of an impure NOEM. Work along these lines would de-emphasize dynamics, general equilibrium, and explicit optimization in favor of a focus on the true innovation of the NOEM literature, which has been highlighting the crucial importance of accounting for imperfect competition and price and wage rigidities in macroeconomic theories of open economies.

Bank equity is exogenous in the standard deposit-and-loan-expansion multiplier model, so that model is inappropriate for analyzing the interaction between monetary and bank regulatory policies. This paper examines the effect of a binding capital requirement on the loan expansion process. We evaluate how the conflict between the monetary and regulatory authorities evolves when bank equity adjusts to a binding capital requirement. We find that capital requirements are not innocuous for monetary policy. Nevertheless, the monetary authority can assert control over the loan expansion process in the long run, although multiplier values will differ considerably from those in the standard multiplier model.

This paper applies a two-country framework that allows for currency substitution in an environment in which policymakers optimally vary interest rates in light of utility-based objectives, one country pegs the value of its currency to the other nation’s currency, and government revenue is generated via explicit taxes and seigniorage. The analysis illustrates the roles that currency substitution, currency preferences, and efficiency of tax systems play in contributing to the likelihood of a “run” on one nation’s currency. We explore how these factors interact to influence the probability of a currency crisis in the country that fixes its exchange rate.

Retail sweep accounts have reduced required bank reserve balances by more than 70% since 1995, raising concerns in some quarters about increased volatility of interest rates and reduced monetary policy effectiveness. We develop a model of bank reserve management and daily payment flows that indicates that the effect of lower reserve balances on funds rate volatility is theoretically ambiguous. We empirically test the relationships among reserve balances, federal funds-rate volatility, and the variation in short-term money market rates. Our conclusion is that reductions in reserve balances have not impinged on the ability of the Federal Reserve to conduct monetary policy in the manner that it has in recent years.

This paper extends Cukierman’s (1992) model of monetary policy discretion, private information, and credibility to an environment in which the quantity of money is endogenous and in which a monetary authority must choose between bank reserves or an interest rate as its instrument of monetary policy. This model is used to explore the determinants of credibility for the alternative policy instruments and to evaluate the manner in which political pressures on a monetary authority can influence the authority’s instrument choice. A key implication of the model is that such political pressures can influence the credibility of monetary policy differentially depending upon the choice of policy instrument, thereby inducing a monetary authority to choose an instrument that otherwise would fail to meet standard Poole (1970) criteria. Keywords: Optimal monetary policy; Monetary policy instruments; Monetary politics JEL classification: E52; E58

This paper analyzes the interaction between two payment systems. Administrators of both systems establish intraday credit interest fees, caps, and collateral requirements. Analysis of the model indicates that if a central bank does not take into account the effects that its policies have on its share of payment system transactions, then its efforts to contain risks associated with daylight overdrafts on its wire system will require a loss in its share of total transactions volume. If it does recognize the potential loss in its share of payments, then socially optimal policy instrument settings are unlikely to emerge.

This paper shows how increased goods market competition affects the behavior of inflation in a multisector economy. By raising the price elasticity of demand, increased goods market competition theoretically lowers inflation and makes the aggregate price level less sensitive to aggregate demand shocks. We find that proxies for the aggregate degree of goods market competition are statistically and economically significant in short-run Phillips curve models of core inflation. Evidence indicates that heightened goods market competition has flattened the slope of the short-run, expectations-augmented Phillips curve and slightly lowered the nonaccelerating inflation rate of unemployment (NAIRU).

This paper shows how economic interdependence affects the indexation decisions of atomistic wage setters in an environment in which monetary authorities do not observe stochastic disturbances before making their policy choices. If stochastic disturbances are common across countries, interdependence has no effect on equilibrium indexation choices in identical countries. However, if disturbances are country specific, numerical simulations show that interdependence is likely to reduce equilibrium indexation choices relative to a small open economy. We also show that indexation choices may be either strategic complements or strategic substitutes, but that strategic complementarity becomes more likely as the degree of interdependence rises.

This paper shows how heterogeneity in wage-setting and a link between goods-market competition and nominal wage indexation can arise in a multisector economy. By raising the price elasticity of demand, increased goods-market competition makes labor demand and equilibrium employment less sensitive to aggregate demand shocks, thereby reducing the incentive to index. We develop a proxy for the aggregate degree of goods-market competition. Along with inflation risk and supply shock variance measures, this proxy is statistically and economically significant in explaining changes over 1958–95 in the share of workers under contract who are covered by indexation clauses.

This paper surveys the literature that uses two-country models to analyze monetary and fiscal policy issues faced in interdependent economies. We discuss sources of structural interdependence that researchers typically include in these models. We describe many of the types of policy interactions that researchers have considered and summarize the key results that they have obtained. Finally, we briefly explain the limitations of two-country models and outline directions that this literature might usefully be extended.