Endogenous market structures in the credit market and Ricardian equivalence

- We analyze endogenous market structures in banking in a dynamic model.
- Ricardian equivalence breaks up with imperfect competition in the credit market.
- Deficits reduce consumption and increase spreads between deposit and lending rates.

We analyze the impact of imperfect competition in banking on fiscal policy in a dynamic model. In an exchange two-period economy the impact of deficit spending is to reduce private consumption and increase the spread between deposit and lending rates. The reason is that a tax cut forces consumers to save more and makes their supply of savings more rigid, which softens competition between banks leading to lower rates on deposits and a more than proportional increase in savings. In a closed production economy this reduces the equilibrium interest rate on borrowers, which promotes private investment.