Optimal banking regulation and monetary policy

Abstract

In a money-search model with deposits as means of payment where banks are subject to limited commitment, we study optimal monetary policy in terms of interest on reserves and inflation, and optimal banking regulations with fiscal constraints on the central bank. The optimal design of banking regulations and monetary policy depends on the amount of productive assets used as collateral for bank deposit issuance and the fiscal requirement. In general, IOER can increase liquidity provision and hence enhance welfare, but it requires fiscal resources to do so, and an appropriate reserve requirement can increase both liquidity and fiscal revenue. This gives a novel channel to improve welfare through banking regulation. However, a positive nominal IOER can also be useful for fiscal purposes under relatively high inflation. For a given level of fiscal requirement, higher welfare is implemented with the consumer’s bargaining power less than one. As consumers hold more deposits for conducting trade, this may raise the tax base, enable less stringent banking regulations, and enhance welfare.