The bank cost function and its relationship to macroeconomic issues

Abstract

A recent trend in economics has been to relate macroeconomic theory to its microeconomic foundations. Of particular interest for this study is the part of this trend involving the link between aspects of monetary theory and banking theory. Previous studies have established a theoretical tie between certain macroeconomic phenomena and properties of a bank's cost function in producing money. Specifically it has been shown that the independence of the money supply and the price level, the neutrality of money, and the size of the real- balance effect depend on characteristics of the cost function. This study presents an empirical analysis of the bank cost function and tests for the existence of these characteristics. We begin with an abstract model of a banking firm. A multiplicative stock maintenance function for demand deposits is assumed, and the cost function is derived by means of constrained cost minimization. The cost function is progressively refined to reflect real-world complications and to render the function suitable for statistical analysis with the available data. From the modified cost function, we formulate hypothesis based on the coefficients of this function, and derive the corresponding tests. Multiple least squares regression analysis is applied cross-sectionally, using Functional Cost Analysis data from participating individual banks in the Sixth Federal Reserve District for 1972, 1973, and 1974. The three regression equations are found to be generally consistent with respect to the signs and values of the coefficients, implying that the underlying function provides a stable relationship between the costs of maintaining a given volume of demand deposits and the explanatory variables..