Introduction

This chapter examines the impact of monetary variables on natural production in a model setting based on rational expectations and full price and wage fiexibility when the wage setting implies a relationship between the real wage and employment, for example, in the case of a monopoly trade union which sets the wage, and when part of financial intermediation takes place through banks. The markets for bank deposits and bank lending are characterised by imperfect competition. The banks have access to investing and borrowing in a market for external finance. It is assumed that this market, termed the securities market, is internationally integrated, the interest rate being determined through uncovered interest rate parity. The chapter demonstrates that inflation and the central bank's reserve policy have an impact on production if one of the following three conditions is met: (i) the bank faces a cost when raising external finance through the internationally integrated securities market, (ii) the bank has preferences with respect to the choice between placing in securities or increasing bank lending, or (iii) there are economies of scope between deposit taking and bank lending. Natural production is furthermore affected by currency restrictions and restrictions on lending.

The basic working of the model can be explained as follows. Legal tender and bank deposits are substitutes in the investor's portfolio.