Banks as coordinators of economic growth and stability: Microfoundation for macroeconomy with externality

Competition among banks promotes growth and stability for an economy with production externality. Following Arrow and Debreu (1954) [6], I formulate a standard growth model with externality—a two-period version of Romer (1986) [39]—as a game among consumers, firms, and intermediaries. The Walrasian equilibrium, with an auctioneer, does not achieve the social optimum. Without an auctioneer or intermediaries, I show that no Nash equilibrium exists. With several banks strategically intermediating capital, a Nash equilibrium emerges with a realistic institution, i.e., an interbank market with a negotiation process in the loan market. The equilibrium outcome is uniquely determined and socially optimal.