A model of the monetary sector with and without binding capital requirements

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.