Assessing the Macroeconomic and Welfare Effects of Government Spending Shocks under Two Banking Systems Via the DSGE Approach

The aim of this research was to examine the macroeconomic and welfare effects of shocks to government consumption expenditure and government investment expenditure under fractional reserve banking and full reserve banking in the Iranian economy. To this end, two New Keynesian dynamic stochastic general equilibrium (DSGE) models were developed, and the behavior of the economy under the two banking regimes was analyzed in a comparative framework. Model parameters were calibrated and estimated using quarterly data for the Iranian economy from 1991 to 2023, using the Bayesian estimation method.The impulse response function analysis indicates that the effects of government fiscal shocks depend critically on the type of banking. Under fractional reserve banking, positive shocks to government consumption and investment expenditures increase output and money supply through the credit channel and endogenous money creation. However, the associated rise in the real interest rate constrains private consumption in the short run and generates more persistent inflationary pressures. In contrast, under full reserve banking, the elimination of bank-based money creation and the direct control of money supply dampen monetary and inflationary fluctuations. As a result, both consumption and output increase, while macroeconomic variables return more rapidly to their steady-state paths. Moreover, the results show that government investment expenditure shocks generate more persistent and less volatile effects on real economic activity than government consumption expenditure shocks. To assess welfare implications, a welfare loss function based on inflation volatility and the output gap was specified, and welfare losses under optimal monetary policy were computed under the two types of banking. The results showed that welfare losses are significantly lower under full reserve banking. In both models, policy configurations that assign a relatively lower weight to output gap stabilization compared to inflation stabilization are welfare superior. Overall, the results suggest that a stronger focus on inflation control by the central bank—particularly within a full reserve banking framework—can reduce macroeconomic volatility and enhance economic stability and welfare.