Banking in General Equilibrium with an Application to Japan

Abstract

Japan has now experienced over a decade of slow growth and deflation. This period has also been associated with protracted problems in the banking sector. A wide range of measures have been tried in to restore health in the banking sector including recapitalization, the extension of 100% guarantees to all deposits, and central bank purchases of shares held by banks. It has also argued that ending deflation is an important ingredient in restoring banking sector health. This paper develops a general equilibrium of the banking sector. In our model the banking sector produces an intermediate good that is used to produce investment goods and a variable fraction of consumption goods. We then assess the implications of alternative policies designed to assist the banking sector in terms of their implications for welfare and the size and profitability of the banking sector.