Monetary Equilibrium and the Cost of Banking Activity

We investigate the effects of banks’ operating costs on allocations and welfare in a low interest rate environment. We introduce an explicit production function for banks in a microfounded model where banks employ labor resources, hired on a competitive market, to run their operations. In equilibrium, this generates a spread between interest rates on loans and deposits, which reflects the underlying monetary policy and the efficiency of financial intermediation. In a deflation or low-inflation environment, equilibrium deposits yield zero returns. Hence, banks soak up labor resources to offer deposits that do not outperform idle balances, thus reducing aggregate efficiency.