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FINANCIAL INTERMEDIATION, LIQUIDITY, AND INFLATION

Published online by Cambridge University Press:  06 January 2011

Jonathan Chiu  and
Césaire A. Meh
Jonathan Chiu*
Affiliation:
Bank of Canada
Césaire A. Meh
Affiliation:
Bank of Canada
*
Address correspondence to: Jonathan Chiu, 234 Wellington Street, Ottawa, Ontario K1A 0G9, Canada; e-mail: jchiu@bankofcanada.ca.
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Abstract

This paper develops a search-theoretic model to study the interaction between banking and monetary policy and how this interaction affects allocation and welfare. Regarding how banking affects the welfare costs of inflation, we find that, with banking, inflation generates lower welfare costs. We also find that lowering inflation improves welfare not just by reducing consumption/production distortions, but also by avoiding financial intermediation costs. Therefore, understanding the nature of financial intermediation is critical for accurately assessing the welfare gain from lowering the inflation rate. Regarding how monetary policy affects the welfare effects of banking, we find that, when the inflation is low, banking is not active in channeling liquidity; when inflation is high, banking is active and improves welfare; and when inflation is moderate, banking is active but reduces welfare. Owing to general-equilibrium feedback, banking is supported in equilibrium even though welfare is higher without banking.

Keywords

SearchInflationBankingMarket for Ideas

Information

Type
Articles
Information
Macroeconomic Dynamics , Volume 15 , Supplement S1: Money, Credit, and Liquidity: Part 1 , April 2011 , pp. 83 - 118
Copyright
Copyright © Cambridge University Press 2011

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References

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