The Effects OF Banking Competition, Monetary …Because of banks’ special role, certain borrowers will not have access to the credit market unless they borrow from banks. As long

The Effects OF Banking Competition, Monetary Policy and Fiscal Policy on Financial Market Activity

Thanarak Laosuthi1*

ABSTRACT To study the impacts of banking competition, monetary policy and fiscal policy on financial market activity, I develop the model in which banks serve important economic functions. The results show that an expansionary monetary policy results in an increase in investment project. Furthermore, the impact is stronger when the banking sector is more concentrated. For the impact of fiscal policy, I demonstrate that if the government runs a budget deficit, it seeks to obtain more funds regardless of the competitive structure of the financial system. As a result, the government crowding out diverts funds away from the investment projects. In this manner, economic outcomes depend on degree of financial competition, monetary policy and fiscal policy. Furthermore, when central bank and the government implement policies, they should account for the interaction between monetary and fiscal policies. Key Words: Banking Competition, Monetary Policy, Fiscal Policy *Corresponding author; e-mail address: [email protected] 1Department of Economics, Faculty of Economics, Kasetsart University, Bangkok, 10900

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สาขาเศรษฐศาสตร์และบรหิารธรุกจิ การประชุมวชิาการของมหาวทิยาลยัเกษตรศาสตร์ คร ัง้ที ่56

mailto:[email protected]

INTRODUCTION Numerous research demonstrates that banks play a significant role in financial markets. One important factor that affects banking performance is the degree of financial competition. To begin, Berger and Hannan (1991) observe that an increase in banking concentration leads to lower rates on deposits. Furthermore, Hannan (1991) and Corvoisier and Gropp (2002) argue that borrowers in markets with higher concentration ratios pay higher interest rates for loans. In addition to market structure, monetary theory states that monetary policy has significant effects on banking activities in the credit market. For example, on the bank lending channel view, banks play a special role in the financial system because they are especially well suited to solve asymmetric information problem in the credit market. Because of banks’ special role, certain borrowers will not have access to the credit market unless they borrow from banks. As long as there is no perfect substitutability of retail bank deposits with other sources of funds, expansionary monetary policy increases bank reserves and bank deposits. This results in a higher quantity of bank loans available. Furthermore, a number of studies indicate that monetary policy has a significant impact on financial activity. For example, Boyd, Levine, and Smith (2001) point out that inflation leads to a lower volume of loans. In addition to monetary policy, government policies can exacerbate the pricing distortions in the banking sector. In addition to inefficiencies from inflation, fiscal policy can interfere with financial market activity. For example, King and Levine (1993) and Pozzi, Heylen, and Dossche (2004) discuss how public sector crowding out diverts funds away from the private sector. Incorporating government debt into the model leads to two important transmission channels in which imperfect competition affects financial market activity. First, as government bonds provide banks with more investment opportunities, government debt introduces additional pricing distortions. Moreover, government debt crowds out loans to the private sector. The reduced availability of funds exacerbates pricing distortions from imperfect competition. In order to address these issues, I develop the model in which banks serve important economic functions. As in Diamond and Dybvig (1983), financial institutions promote risk sharing services in the economy. Furthermore, the role of money is well defined. In particular, following Townsend (1987) and Schreft and Smith (1997), spatial separation and private information generate a transactions role for money.

SCOPE OF THE STUDY This study aims to provide theoretical framework for the effects of banking competition,

monetary policy and fiscal policy on financial market activity. In an attempt to address these issues, I develop a model in which banks play an important role in the economy. As in Diamond and Dybvig

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การประชุมวชิาการของมหาวทิยาลยัเกษตรศาสตร์ คร ัง้ที ่56 สาขาเศรษฐศาสตร์และบรหิารธรุกจิ

(1983), financial institutions promote risk sharing services in the economy. Furthermore, the role of money is well defined. In particular, following Townsend (1988) and Schreft and Smith (1997), spatial separation and private information generate a transactions role for money.

MODEL

1. Environment By following Schreft and Smith (1997), I consider a discrete-time economy populated by an infinite sequence of two-period lived overlapping generations, plus an initial old generation. In particular, the economy consists of two geographically separated islands. At the beginning of each time period, a new generation of individuals is born on each island with a population measure equal to 1. Although the population resides in two separate locations, there is a single consumption good available on both islands. Individuals derive utility from consumption when old. Their preferences are given by:

2 2( ) ln(c )u c (1) When young, agents are endowed with 0x units of the consumption good. While agents do not receive endowments in their old-age, they have access to a storage technology. For each of unit of goods allocated to the technology when young, agents receive 0 1s units of consumption in the following time period. Private information serves as the primary trade friction in the economy. Thus, communication across islands is not possible. Moreover, individuals in the economy are subject to relocation shocks. Each period, a fraction of young agents must move to the other island. The probability of relocation, , is exogenous, publicly known, and the same in each island. Agents may carry goods across locations. However, transportation involves resource costs — a fraction of goods, (0,1) , will depreciate during the relocation process. 2. Autarky Economy In an autarky economy, individuals do not have access to financial intermediation or a money market. At the initial stage of period t , old relocated individuals carry the goods that they save from the previous period to the other location. Due to the transportation cost, they consume (1 )s x units of goods. Individuals who do not experience relocation shocks, non-movers, consume the entire returns from storage, sx . At the end of period t , old agents in generation 1t die and the relocation shock occurs. Therefore, an individual’s expected lifetime utility, ( (C ))AE U , is a probability-weighted average of the lifetime utility obtained across states. To be specific, it is given by: ( ( )) ln(1 ) (1 ) ln( )AE U C sx (2)

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3. An Economy with Financial Intermediation I proceed by integrating financial markets into the framework. However, in contrast to standard random relocation models, agents have limited ability to participate in the financial system. Although one or many different financial intermediaries may be available, individuals only obtain access to financial markets indirectly through the services of banks. With deposits received, banks can allocate funds to investment projects which yield for 1R each unit of goods invested in the previous period. Moreover, banks also have the ability to trade in a market for money balances. Although the investment opportunities generate higher returns than storage, private information across islands limits trading opportunities in the economy. That is, the trade friction of private information prevents movers from issuing claims to investments across islands. Consequently, as in autarky, only non-movers consume the full returns from investments. Furthermore, spatial separation and private information generate trade frictions in the economy. Consequently, private liabilities do not circulate between the two locations. Moreover, a relocation shock occurs on each island. In particular, a fraction of young lenders ( ) must move to the other island. As a result, fiat money is the only asset that agents can carry to the other location and exchange for goods. Therefore, the relocation shock plays the role of a liquidity preference shock in the Diamond-Dybvig model and fiat currency helps individuals to avoid trading frictions. This allows fiat money to be dominated in rate of return. The return to fiat money depends on the total amount of currency in the economy. I let

tm denote the per capita real value of the monetary base on each island and denote the net growth rate of money. Therefore, the money supply for t>0 evolves according to: 1 1 (1 )t t t tm p m p (3)

In addition to monetary policy, fiscal policy can interfere with financial market activity. Incorporating government debt into the model leads to two important channels. First, government bonds provide banks with more investment opportunities. Second, government bonds can divert funds away from the private sector. In particular, the government can issue interest-bearing bonds ( s

tb ) and collect tax ( tT ) to finance government expenditure tG and the bonds from the previous period ( 1

s

tb ). As aresult, there are three primary assets: fiat money, loans, and government bonds. All bonds are of one-period maturity and default-free. One unit of goods held in bonds at t ( s

tb ) constitutes a sure claim to bR units of goods at 1t . Thus, the government need only manipulate the supply of its liabilities to guarantee that it can meet its interest obligations in each period. The government budget constraint is given by: 1

s b s

t t t tb T G R b (4)

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Next, I describe the timing of actions in the economy. Banks announce deposit return schedules that depend on depositor-withdrawal dates and lenders deposit their funds. Based upon deposits received, banks choose portfolios that consist of currency reserves, investment projects, and government bonds. Money balances are obtained by receiving transfers of fuat money from the monetary authority and by trading some of the deposits to relocated old agents. The rest of deposits will be invested in the investment projects and the bond market. When the previous bond market is settled, banks use the funds to finance payments to nonrelocated individuals. At the end of the period, the relocation shock occurs and old borrowers die. 4. Perfectly Competitive Banks Banks compete for deposits by offering a schedule of rates of return to deposits. Thus, a set of actions is a Nash equilibrium if a bank cannot increase its profits in the deposit market by choosing a term structure to deposits other than its equilibrium action. Since financial intermediaries offer identical services, individuals will establish their accounts with the bank offering deposit rates providing more utility. Consequently, the deposit market is effectively perfectly competitive. In this manner, if there are more than one identical depository institutions in the economy, each financial intermediary chooses rates of return to deposits to maximize the expected utility of a representative depositor. The bank’s objective is:

, ,c ,i ,b

ln( ) (1 ) lnm n PC PC PCt t t t t

m n

t t

r r

r x r xMax (5)

Furthermore, the bank’s portfolio allocations must satisfy the balance sheet constraint:

pc pc pc

t t tx c i b (6) Since currency is the only asset that can be transported across locations, the return to relocated agents is constrained by the amount of currency holdings and the inflation rate:

1 1

m pc t tt t t

t t

p pr x c m

p p

(7)

In addition, money is dominated in rate of return. Therefore, intermediaries will not carry balances between periods. As a result, banks use the revenues from investment projects and the bond market to finance payments to nonrelocated agents:

(1 ) n pc b pc

t t t tr x Ri R b (8) As in the previous section, banks can prevent liquidity crises by offering a schedule of deposit rates so that nonrelocated agents receive higher returns than relocated agents: m n

t tr r (9)

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This constraint also reflects the requirement that money is dominated in rate of return. Finally, in order to induce individuals to deposit their funds in the bank, the expected utility of each depositor must satisfy a participation constraint. Instead of the bank, agents may choose to put funds in the storage technology. Consequently, individuals must obtain higher expected utility than the autarky level:

ln( ) (1 ) ln ( ( ))m n A

t tr x r x E U C (10) 5. A Monopoly Bank In contrast to perfectly competitive banks, a monopolist chooses to earn the highest possible profits. Consequently, a monopolist chooses a schedule ( m

tr , n

tr , mp

tc , mp

ti , mp

tb ) such that:

, , , , 1 1

(1 )m n mp mp mp

t t t t t

mp m mp b mp nt tt t t t t t

r r i m b t t

p pc m r x Ri R b r x

p pMax

(11)

subject to a balance sheet constraint: mp mp mp

t t tx c i b (12) As in perfectly competitive economy, relocated agents cannot access their account in the other location due to limited communication. As a result, they must use fiat money to trade for goods. Thus, the payment to relocated individuals is given by the amount of reserves:

1 1

m mp t tt t t

t t

p pr x c m

p p

(13)

In contrast, agents who do not move can keep their funds in the bank. The rate of return will be determined by returns from the investment project and government bonds. Consequently, the return to nonrelocated agents is constrained by:

(1 ) n mp b mp

t t tr x Ri R b (14) In addition, if the return of relocated agents is more than the return of nonrelocated agents, individuals will lie about their types. For these reasons, the self-selection constraint must also hold: m n

t tr r (15) Obviously, the return to fiat money is dominated by the return on long-term investment

opportunities. Then, a monopolist offers a rate of return to movers such that:

1 1

m mp t tt t t

t t

p pr x c m

p p

(16)

However, a monopolist wants to obtain profit so the revenues from investment project and government bonds must higher than the return to nonmovers:

(1 )mp b mp n

t t tRi R b r x (17)

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RESULT 1. An expansionary monetary policy results in an increase in investment project. Furthermore, the impact is stronger when the banking sector is more concentrated. When banks receive more money transfers from monetary authorities, they can allocate more funds to investment project. This happens because money transfers from central bank leads to higher level of liquidity insurance. Consequently, banks do not have to hold more currency. They can allocate more funds to investment opportunities. Furthermore, the impact is stronger when the banking sector is more concentrated. In particular, perfectly competitive banks want to maximize expected utility of depositors while a monopolist aims to maximize profits. Therefore, perfectly competitive banks will hold more currency compared to a monopolist. Furthermore, agents are risk averse. They want to get more insurance in the bad state. Thus, the amount of investment opportunities in perfectly competitive banking sector will be lower compared to the amount of investment opportunities in a monopoly. 2. Regardless of the competitive structure of the financial system, an expansionary monetary policy leads to the higher amount of investment projects. However, the impact of monetary policy is weaker if the government runs a budget deficit. When monetary authorities implement an expansionary monetary policy, banks are able to allocate more funds to investment opportunities. As a result, the amount of investment projects increases. However, if the government runs a budget deficit, it seeks to obtain more funds. As a result, the government crowding out diverts funds away from the investment projects. 3. If the rate of return of government debt is sufficiently high, an increase in the rate of return of government debt is associated with the lower amount of investment opportunities. Furthermore, the effect is weaker when the banking sector is more concentrated. The rate of return to government debt reflects the opportunity cost of investment projects. If government bonds yield a higher rate of return, the opportunity cost increases. As a result, banks invest less in investment projects. Moreover, the effect is weaker when the banking sector is more concentrated. This occurs because the rate of return in the bond market also represents the opportunity cost of holding money. When the rate of return to government debt is higher, the opportunity cost of holding money increases. Thus, a monopolist can maximize profits by holding less reserves. Thus, it can allocate more funds to assets that yield higher rate of return. Therefore, the amount of investment opportunities decreases by small amount. In contrast, perfectly competitive banks wants to maximize the expected utility of depositors. Agents are risk averse so they want to get liquidity insurance in the bad state. In this manner, the rate of return to government bonds is

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independent of the amount of currency holding. Thus, when the government bonds yield a higher rate of return, most funds are diverted away from the investment projects.

CONCLUSION

I demonstrate that an expansionary monetary policy results in an increase in investment project. Furthermore, the impact is stronger when the banking sector is more concentrated. For the impact of fiscal policy, the results show that, regardless of the competitive structure of the financial system, an expansionary monetary policy leads to the higher amount of investment projects. However, the impact of monetary policy is weaker if the government implements a budget deficit. Moreover, an increase in the rate of return of government debt is associated with the lower amount of investment opportunities and the effect is weaker when the banking sector is more concentrated. In this manner, when central bank and the government implement policies, they should account for the interaction between monetary and fiscal policies.

REFERENCES Berger, A. and T. Hannan, 1991. The Price-Concentration Relationship in Banking. Review of

Economics and Statistics, 24, 291-99. Boyd, J., R. Levine, and B. Smith, 2001. The Impact of Inflation on Financial Market Performance.

Journal of Monetary Economics, vol. 47, pp. 221—48. Corvoisier, S. and R. Gropp, 2002. Bank Concentration and Retail Interest Rates. Journal of Banking

and Finance, 26, 2155-2189. Diamond, D. and P. Dybvig, 1983. Bank runs, Deposit Insurance, and Liquidity. Journal of Political

Economy, 85, 191-206. Hannan, T., 1991. Bank Commercial Loan Markets and the Role of Market Structure: Evidence from

Surveys of Commercial Lending, Journal of Banking and Finance, 15, 133-149. King, R. and R. Levine, 1993. Finance and Growth: Schumpeter Might be Right. Quarterly Journal of

Economics, 108, 717-737. Pozzi L., F. Heylen, and M. Dossche, 2004. Government Debt and Excess Sensitivity of Private

Consumption: Estimates from OECD Countries. Economic Inquiry, 42(4), 618-633. Schreft, S., and B. Smith, 1997. Money, Banking and Capital Formation. Journal of Economics

Theory, 73, 157-182. Townsend, R., 1987. Economic Organization with Limited Communication. American Economic

Review, 77, 954-971.

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The Effects OF Banking Competition, Monetary …Because of banks’ special role, certain borrowers will not have access to the credit market unless they borrow from banks. As long