Bank Capital and Monetary Policy ∗

This paper develops a quantitative, monetary model in which agency problems affect both the relationship between banks and firms as well as that linking banks to their depositors. As a result, bank capital and entrepreneurial net worth jointly determine aggregate investment, and help propagate over time shocks affecting the economy. We find that the effects of monetary policy shocks depend on the capitalization of the banking system. More specifically, in an environment with a low average capital asset-ratio, monetary contractions lead to more substantial declines in economic activity than they do in an economy with highly capitalized banks. ∗This paper was prepared for the workshop “Dynamic Models Useful for Policy”, organized jointly by the Bank of Canada, the Federal Reserve Bank of Cleveland, and the Swiss National Bank and held at the Bank of Canada, July 10-11, 2003. We thank Andrés Erosa, Martin Gervais, Igor Livshits, Gueorgui Kambourov, Iourii Manovskii, Miguel Molico as well as seminar participants at the University of Western Ontario, the University of Toronto, the Bank of Canada, and the 2003 annual conference of the Canadian Economic Association for useful comments and discussions. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. †Department of Monetary and Financial Analysis, Bank of Canada: 234 Wellington, Ottawa, Ontario, Canada K1A 0G9. Email: [email protected] and [email protected].