Exploring the Impact of Shocks on Welfare Loss in Fractional and Full Reserve Banking: DSGE approach

Document Type : RESEARCH PAPER

Authors

1 Assistant Professor of Economics, Shahid Beheshti University,Tehran,Iran

2 2. Assistant Professor of Economics, Shahid Beheshti University, Tehran,Iran.

Abstract

The purpose of this study is to investigate the effects of shocks on welfare loss under fractional and full reserve banking. To achieve this goal, we designed a stochastic dynamic general equilibrium model of the new Keynesians, considering the fractional and full reserve banking system (FRB) and the realities of the Iranian economy. We then examined the effects of impulses under two scenarios. After determining the model input values and estimating the parameters using quarterly data from Iran’s economy during the period of 1991-2021 via the Bayesian estimation method, the results of the model variables simulation validate the model’s ability to describe the fluctuations in Iran’s economy. Examining the dynamics of the model shows that the final result of shocks in fractional reserve banking on most of the real and financial sector variables is longer and larger than in full reserve banking. Also, the comparison of the response functions of the selected variables in the two models shows that banking has caused the share of shocks in creating the fluctuations of key variables to change, and even the position of some of them with oil shocks and money changes. Regarding the welfare loss of shocks in two basic and optimal models, the results showed that the lowest welfare loss is related to the optimal model (full reserve). The lowest welfare loss in the basic model (0.01479200) and the optimal model (0.00001306) corresponds to the case where the coefficient of the production gap in the loss function is equal to 0.5. That is, if the inflation priority is applied to the loss function, the numerical value of the welfare loss is significantly smaller than the other investigated cases. This confirms that in both models, the priority of inflation is more effective than the priority of production in the CB loss function in terms of welfare. This means that the Central Bank of Iran should pay more attention to inflation between inflation and production fluctuations because the full reserve of deposits has a greater impact on inflation.

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References

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