Martin Shubik, Eric Smith

Paper #: 14-03-003

We consider the problem of financing two productive sectors in an economy through bank loans, when the sectors may experience independent demands for money but when it is desirable for each to maintain an independently determined sequence of prices. An idealized central bank is compared with a collection of commercial banks that generate profits from interest rate spreads and flow those through to a collection of consumer/owners who are also one group of borrowers and lenders in the private economy. We model the private economy as one in which both production functions and consumption preferences for the two goods are independent, and in which one production process experiences a shock in the demand for money arising from an opportunity for risky innovation of its production function. An idealized, profitless central bank can decouple the sectors, but for-profit commercial banks inherently propagate shocks in money demand in one sector into price shocks with a tail of distorted prices in the other sector. The connection of profits with efficiency-reducing propagation of shocks is mechanical in character, in that it does not depend on the particular way profits are used strategically within the banking system. In application, the tension between profits and reserve requirements is essential to enabling but also controlling the distributed perception and evaluation services provided by commercial banks. We regard the inefficiency inherent in the profit system as a source of costs that are paid for distributed perception and control in economies.