This thesis consists of theoretical work studying the creation of money by commercial banks. The principal way by which money is created in the modern economy is through commercial banks granting loans. This makes for a tight connection between issuance of money and issuance of credit, a link often abstracted from by theory of banking and theory of money alike. My work aims to address to theoretical lacuna.
In the first chapter, I develop a model to compare private banking with and without issuance of inside money in the same physical environment. A private bank’s on-demand claims to outside money–demand-deposits–may or may not circulate as a medium of exchange. The bank is fully committed to honouring its promises and perfectly anticipates all withdrawals in equilibrium. I show that by intertwining the credit and money markets, the bank’s issuance of inside money, i.e., issuance of demand-deposits beyond the bank’s stock of outside money, can influence the real interest rate. Via the effect on the real interest rate, the bank’s creation of money in turn propagates to every economic decision that spans time, resulting in relatively higher production of future goods versus present goods, lower willingness to save overnight and higher willingness to borrow (the gap being made up by money-issuance), as well as inducing firms and banks to pay out dividends rather than retaining earnings and to build up their capital. Since the channel I focus on has nothing to do with swings in the money supply, or with the disruptions of bank runs, the effect on the real interest rate arises even in steady state equilibria with a constant total money supply and price level.
In the second chapter, I explore the implications of the private bank’s money-issuance for the effect of monetary policy. I show that while labour effort and total output is negatively related to higher rates of inflation in the absence of inside money, the opposite may hold true when the private bank grants loans by creating inside money. This suggests that a proper modelling of commercial banks' issuance of inside money is important also for a correct assessment of the channels of monetary policy, and its effect on the real economy.