Loanable funds versus money creation in banking: a benchmark result

Abstract

We establish a benchmark result for the relationship between the loanable-funds and the money-creation approach to banking. In particular, we show that both processes yield the same allocations when there is no uncertainty. In such cases, using the much simpler loanable-funds approach as a shortcut does not imply any loss of generality. When there is aggregate risk with complete contracts and complete markets, we indicate that a restricted equivalence result holds.

Why Bank Money Creation?

“…Our analysis also allows to assess whether the standard LF approach, which is typically used in macroeconomic modeling, is a valid shortcut for modeling the banking sectors' main role within the economy. In contrast to Faure and Gersbach (2022), who show that the LF economy and the MC economy produce equivalent outcomes when considering an environment without moral hazard at bank level, our findings show that this result does not carry over to a setting with heterogeneous banks and financial frictions. An inefficiently low allocation of capital to bank-dependent firms, due to bank-level moral hazard, turns out to be less of a worry in our actual monetary system with bank money creation than what the LF approach would suggest.…”