Introducing banks into the macroeconomic model

From the second half of the twentieth century, the role of banks in macroeconomics was neglected in Keynesian (IS-LM models) and later in monetarist models. Both approaches were concerned with money and bank liabilities, rather than with bank assets or bank credit, with the money supply process, rather than with the credit supply.

John J. Gurley and Edward S. Shaw in Money in a Theory of Finance (1960) presented an analysis of the banking system through a general theory of the choice of optimum asset and debt portfolios by financial institutions of various kinds. They distinguished between “direct finance” and “indirect finance” as different ways for firms to be financed, and highlighted the role of financial intermediaries at the macroeconomic level, which cannot be substituted by markets. The intermediaries provide ultimate lenders with new types of securities and expand the borrowers’ “financial capacity” (their balance sheets), which is an important determining factor of aggregate demand. They made the distinc­tion between “inside money” (based on private domestic debt) and “outside money” (based on any other asset). Patinkin in Money, Interest and Prices (1956 [1965]) would later discuss the relevance of this distinction for the determination of the price level.

Other authors were to reformulate the macroeconomic model. The fact that, in a reces­sion, the rate of interest will be stable or rise instead of diminishing cannot be explained by the “standard” theory at the root of the LM curve, but it can be explained if we intro­duce the credit supply curve.

Information asymmetries are at the root of the reintroduction of banks into economic theory. There will be macroeconomic consequences of imperfect information in financial markets. Supply of credit is based on a judgement regarding the debtor’s solvency, a spe­cific piece of information that is not transferable, and that is produced over a long-term relationship with banks. This customer relationship creates a “sunk cost” but reduces information costs later. Thus, bank credit and other market securities do not substitute for one another and some firms are dependent on banks; they cannot obtain funds on markets. The channel of monetary policy does not work solely through the demand for money, which involves the cash balance effect or the substitution effect in the portfolio choice between two types of assets: bonds and money. It also operates through the supply of credit by banks to agents who need to borrow from them (a credit availability effect). The credit market is introduced into the macroeconomic model. The bank lending rate is thus distinguished from the other market rates. This credit channel shows how a “mon­etary shock” will be transmitted to the real sector by banks through their credit supply. The central bank can affect the asset side of the banks’ balance sheet (their credit supply), not only the liability side through their deposits. This was introduced into the IS-LM model (Bernanke and Blinder 1988) through a new kind of shift of the IS function, that is now called a CC (commodities and credit) function.

In this perspective, it is possible to describe the effects of a restrictive open market policy on the asset side of banks’ balance sheets. Bank liquidity will diminish. Banks counteract this effect not by issuing debt securities, nor by selling short-term securities because they need to keep liquid assets, but by reducing the amount of loans. In this way, a reduction in economic activity could be possible without a change in market interest rates. However, monetary policy can have another effect, through a rise in the lending interest rate, which will damage balance sheets and the collateral of the firms that are borrowing. This will then reduce their direct or intermediated borrowing capability. It operates like a “financial accelerator” in the event of a shock.