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 naturally 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 end up soaking up labor resources to offer deposits that do not outperform idle balances, thus reducing aggregate efficiency.
Boel, P., & Camera, G. (2019). Monetary equilibrium and the cost of banking activity. ESI Working Paper 19-12. Retrieved from https://digitalcommons.chapman.edu/esi_working_papers/270/