Banks and inflation

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Virginia Polytechnic Institute and State University

This dissertation examines three aspects of banking behavior: (a) involvement of banks in inflationary processes, (b) the effects of inflation on bank earnings and (c) the portfolio behavior of banks in an inflationary period. The study first traces the evolution of the"credit theory of inflation" from the eighteenth century to the early twentieth, and finds that under certain conditions banks may ignite an inflationary process by failing to adjust their loan rates to the real rate of interest.

The analysis of the second aspect of banking behavior is carried out at the micro-economic level. After a critical appraisal of Martin Bailey's macro model of banking behavior under conditions of fully anticipated inflation and a competitive market structure, the study finds that Bailey's conclusion as to the favorable effects of inflation on bank profit is inconsistent with his model. The study revises Bailey's model and develops two models of banking behavior along the lines of the neoclassical approach of manufacturing firms. The first model examines banking performance under conditions of a competitive market structure and fully anticipated inflation. The model predicts that under these circumstances the banking system is more likely to lose than gain from inflation. The second model analyzes banking behavior when the banking market is characterized as monopolistic. It is inferred that no definite conclusions may be drawn with regard to the effects of inflation on bank earnings without an empirical knowledge of the parameters of the demand for loans and the supply of funds to the banking system.

The study also analyzes banking behavior under conditions of unanticipated inflation. It is found that if savers respond to changes in the rates of interest only after a time lag, or if their subjective probability distribution of expected returns on income earning assets is biased downward, banks are in a position to earn some windfall gains from inflation.

The third section of the dissertation analyzes bank portfolio behavior under both anticipated and unanticipated inflation. It is shown that unanticipated inflation forces the banks to alter their portfolio of income earning assets, and it is argued that such activities by banks may nullify the restrictive monetary policies that the monetary authority may impose upon the money market to slow down the rate of inflation.

The study also presents evidence on the profitability of Chilean commercial banks during 1937 to 1950, and finds that due to the special rediscounting provisions of the Chilean Central Bank these banks earned more than average rates of return on their capital outlay, The study also suggests that the Chilean commercial banks were instrumental in perpetuating the inflation.

Evidence is also presented on the portfolio behavior of U.S. commercial banks for the period 1950 to 1970. It is shown that the U.S. commercial banks moved from long-term assets to short-term assets during all the expansion periods observed between 1950 to 1970. This behavior by U.S. commercial banks is explained by the differential impact of the unanticipated inflation on short-term and long-term rates of interest for the period under review.