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A microeconomic theory of the financial firm

University of British Columbia

This research develops a microeconomic theory of the financial firm that is empirically implementable. Financial firms such as banks and savings and loan associations produce intermediation services between borrowers and lenders. User costs per unit of service can be derived for all goods. For financial services, these include the effects of reserve requirements, capital gains or losses, deposit insurance, interest rates, and service charges. Items generating more expenditure than revenue for the firm have positive user costs, and are inputs. Those with negative user costs are outputs. Comparative statics on profits, supplies of output and demands for input are derived for interest rates and monetary regulations. Data comprise pooled time series and cross section data for eighteen banks in New York and New Jersey for the years 1973-1978. User cost and quantity data are constructed for loans, demand deposits, time deposits, cash, labour and materials. The first two are outputs and the last four inputs. A specification is derived for the variable profit function, and the testing of regularity conditions such as monotonicity and convexity described. A test for the existence of a money supply, as a subset of financial goods is developed. The test imposes no prior restriction on the form of the money supply. The empirical results indicate that convexity and monotonicity obtain, at the geometric mean of the sample. Elasticities of supply for outputs are positive, but less than unity. Elasticities of demand are negative. Bank response to any monetary policy action can be calculated, and some experiments are reported on. An alternate model is derived to permit imperfect competition in the financial firm market for outputs and inputs. The model is shown to yield testable predictions, and price taking behavior for these banks is ruled out. The results indicate that it is possible to develop and implement a model of financial firm behavior. Such a model is required to ensure accuracy in the effectiveness of monetary policy.

Text

2010-05-02

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http://hdl.handle.net/2429/24277

Economics

University of British Columbia

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