Banking and monetary policy in a monetary union

We model the banking systems of a two-country monetary area with a single central bank. Banks can operate either locally or in national loan markets and participate in an area-wide interbank market. This model determines open-market and retail bank interest rates and equilibrium allocations of the banks’ assets and liabilities in relation to the exogenous policy choices of the central bank and its subsequent balance sheet allocations. We find that loan and deposits markets are interdependent and that regional shocks generate inter-regional spillovers. The central bank of our model has several alternative tools to provide liquidity and to influence all the short-term interest rates of the monetary area. We analyze the effects of various alternative central bank policy instruments in both scarce and abundant-reserves regimes.