Staff Working Paper No. 752
By Michael Kumhof and Xuan Wang
We study a New Keynesian model where banks create deposits through loans, subject to increasing marginal cost of lending, and where all non-banks must use deposits to make payments. We discuss three implications. First, non-banks do not face budget constraints but deposits-in-advance constraints, and both individual and aggregate purchasing power can be increased beyond prior income through ex-nihilo deposit creation. Second, at the ZLB on deposit rates (ZLBD) further policy rate reductions reduce spreads, and thereby reduce bank profitability, deposit creation and output. Third, at the ZLBD Phillips curves are flatter because credit rationing is both contractionary and inflationary.
This version was updated in July 2019.