We study the behavior and economic impact of oligopolistic banks in a tractable macro environment with micro-foundations of money and banking. Our model has three key features: (i) strategic interaction of banks with market power; (ii) bank liquidity problem arising from mismatched timing of payments; and (iii) search frictions in credit, labor and goods markets. Our main …ndings are the following: First, it is welfare-maximizing to have the banking sector as oligopolistic, i.e., to have a small number of large banks. When the bank number is small, having more banks improves welfare because competition stimulates aggregate lending, allowing for greater …rm entry and higher output. Nevertheless, as the bank number increases, the banking sector’s demand for funds also grows, which bids up the value of funds. Accordingly, the deposit rate will rise, causing the cost of bank lending to go up. In turn, banks start to charge a higher loan rate, which raises the cost of borrowing for …rms. At this point, the increased cost of funds leads to less bank lending, lower …rm entry and output, and thus reduced welfare. Second, bank competition can actually widen the interest rate spread. With a small number of banks and ample deposits supplied to the sector, competition results in a lower loan rate as more banks join in. However, when the bank number is large enough, the banking sector will fall into a binding liquidity constraint in the sense that aggregate lending is constrained by the supply of deposits to banks. With this binding constraint, more intense bank competition will make the loan rate increase, instead of falling. This rise in the loan rate dominates the rise in the deposit rate, which leads to a wider spread. Finally, inflation can change the nature of the banking equilibrium. Higher inflation is more likely to steer the economy into a bad equilibrium where banks su¤er from the binding liquidity constraint.

Presented by Mei Dong, University of Melbourne.

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