Understanding Monetary Policy: The Real Sector and Welfare

This paper shows theoretically the linkages among monetary policy rate, the real sector demand for loans with supply shocks, aggregate risks, and social welfare. We prove that a) when the loans’ demand is elastic bank competition and the policy rate decrease risks and increase the amount of lending to firms b) these effects are reinforced as the number of banks in the banking market raises. We provide theoretical support to the empirical findings that a competitive environment, or an elastic demand for investments, renders the monetary policy more effective and increases welfare (Aghion et al 2019), on the contrary, uncompetitive structures obtain opposite effects (Wang et all 2022). The policy implications are that the welfare maximizing policy rate can be lower it could be lower than set by the Central Bank when there is high inflation (Rogoff, 2017). c) As in this economic phase of perfect diversification difficulties because of aggregate risks, the policy rate is more effective in welfare increasing if the banking sector is competitive.