Oligopoly Banking, Risky Investment, and Monetary Policy

Abstract

Oligopolistic competition in the banking sector and risk in the real economy are important characteristics of developed economies, but so far they have mostly been abstracted from monetary models. We build a dynamic general equilibrium model of monetary policy transmission that incorporates both of these features. We document that including them leads to important insights in our understanding of the transmission mechanism. Various equilibrium cases can occur, and policies have differing effects in these cases. We also calibrate the model to the U.S. economy during 2016-2019. We find that doubling banking competition would have increased welfare by 1.02%, but at the cost of increasing the probability of bank default from 0.02% to 0.44%. We show that bank profits are increasing in the policy rate, in particular when interest rates are low. Finally, we find that monetary policy pass-through is incomplete under imperfect competition in the banking sector.

Keywords: Oligopoly competition, Risky investment, Financial intermediation, Monetary policy

JEL Classification: D34, G32, G21, E52