On a pecuniary externality of competitive banking through goods pricing dispersion

Abstract

We study the interaction between banking, endogenous market power with price dispersion in goods markets, and reserve requirement regulation. If the reserve requirement never binds, then the economy is a banking generalization of Head et al. (2012): the addition of banking has no pecuniary externality on goods trades and banking is always welfare improving. If the reserve requirement binds, there is a positive spread between lending and deposit rates. In this empirically-relevant case, there is a pecuniary externality: banking amplifies retail-goods firms’ market power. Credit- and policy-dependent heterogeneity in retail-good markups implies a non-monotonicity in the welfare-improving role of banks. We explain the novel opposing forces at work. Our model also justifies why policymakers should be worried about the nexus between inflation, banking and industry markups.