We develop a monetary economy in which market power in lending is endogenous and responds to policy. The theory can account for both dispersion of loan interest rates and incomplete pass-through of monetary policy to them. The model implies positive and negative relationships, respectively, between the dispersion of loan rate spreads as measured by their standard deviation and coefficient of variation and the average spread. This is a distinguishing feature of our search-based theory of market power and is consistent with new micro-level evidence on U.S. consumer loans. Imperfect competition in lending also creates a novel channel from monetary policy to loan-rate spreads, and thus, to real consumption and welfare. At low inflation, banks tend to demand higher rates from existing loan customers rather than compete for additional loans. As a result, banking activity need not improve welfare if inflation is sufficiently low. Under a given inflation target, welfare gains arise if a central bank uses state-contingent monetary injections (or manages the nominal interest rate) to reduce lenders’ market power when aggregate demand is high at the cost of allowing it increase when demand is low.
QED Working Paper Number
Money, Banking, Credit; Loan Spread; Price Dispersion; Market Power; Stabilization Policy; Liquidity.