Growth effects and welfare costs in an innovation-driven growth model of money and banking

Abstract

Abstract This paper analyzes the effects of three distinctive monetary instruments, namely, the money growth rate, the required reserve ratio, and the leverage ratio, on growth and welfare in an R&D growth model with an active banking sector and financial frictions. Our analytical results show that increasing the money growth rate, required reserve ratio, and leverage ratio requirement have negative effects on the balanced growth rate. The relative magnitudes of their growth effects depend on the components of the banking capital structure that the monetary instruments can regulate and influence. Our calibration results show that the required reserve ratio gives rise to the most pronounced effects on economic growth and welfare costs, while the money growth rate has the least pronounced effects on both of them. Nevertheless, the extended analysis shows that the growth effects and welfare costs of the leverage ratio requirement may become the greatest if the costs arising from converting loans to production are substantially large. This implies that the choice of a better monetary instrument relies on banking efficiency. In the model, the welfare costs generated by the money growth rate can be larger than shown in previous studies due to the presence of financial frictions.