obtains. Thus for economies with low (high) real deposit rates and/or heavy (limited) reliance on general revenue to fund deposit insurance, it will be the case that higher reserve requirements lead to lower (higher) rates of bank failure. Again the number and type of steady state equilibria that exist can also depend in a complicated way on the choice ofθ.
savings, and the rate of inflation within a given equilibrium. Thus there is no general presumption that something like actuarially fair deposit insurance premia have any good properties. Nor need high reserve requirements – in effect, movements in the direction of narrow banking – have a salutary effect on bank failure rates. Finally, it is by no means clear that large implied subsidies to the banking system associated with deposit insurance provision have any negative consequences. Moreover, when such subsidies exist, it will generally enhance the safety of the banking system to monetize them, at least to some extent. And, doing so need have very little adverse inflationary impact relative to the policy of financing such subsidies out of general tax revenue.
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Diamond and Dybvig meet Kiyotaki and Wright
Ricardo de O. Cavalcanti
EPGE, Getulio Vargas Foundation, Praia de Botafogo, Rio de Janeiro 22253-900, Brazil [email protected]
Summary. A model is presented in which banks update public records, ac- cept deposits of fiat money and intermediate capital. I show that inside money is more liquid than outside money, increasing the turnover rates of idle capital.
The model offers a simple explanation for the dual role of financial institu- tions: Banks are monitored and can issue nominal assets upon request, which helps them to transfer capital in sufficiently high rates and to also become intermediaries. The model shares some features with those of Diamond and Dybvig [5], and Kiyotaki and Wright [7].
1 Introduction
In this paper, I show in a simple model that the provision of inside money should be coordinated with the intermediation of capital, in contrast to well-known proposals for regulating the financial system that recommend money and credit be separated.1 The model described in this paper builds on the sharing of storable goods, emphasized by Diamond and Dybvig [5], and the creation of inside money that appears in recent extensions of the model of Kiyotaki and Wright [7].2 In my model, banks are well monitored, and can credibly provide a supply of fiat money to clients who turn out to need liquidity. The added liquidity increases capital turnover and hence the reliability of the intermediation provided. As a result, banks can become both conservative issuers of inside money and trustworthy receivers of idle capital. Therefore, the dual role of money issuer and capital intermediary is well-suited to banks.
I thank two anonymous referees, Susumu Imai, B. Ravikumar and Neil Wallace, as well as participants at theEconomic Theorysymposium “Recents Developments in Money and Finance,” and seminar participants at the Richmond Fed, Queens University, and Sabanci University for comments on an early draft. The hospitality and financial support of the Cleveland Fed Central Bank Institute and CNPq are greatfully appreciated. The author’s opinions are not necessarily those of the Federal Reserve Bank of Cleveland or the Federal Reserve System.
1Commercial banks have historically played active roles in both payment systems and capital intermediation. Not surprisingly, episodes of bank failure have led Friedman [6] and others to express concerns that movements in the demand for money would interact with credit activities in undesirable ways, generating financial fragility.
2See Cavalcanti, Erosa, and Temzelides [2].
The paper is organized as follows. A preview of the results, as well as a deeper motivation of the model, is presented in Section 2. The formal description of the environment, with monitored banks and a nonbank public, is described in Section 3.
In Section 4, I present a benchmark version of the model in which the nonbank public uses outside money and there is no intermediation. The set of allocations considered in this version is helpful for showing that in the limit, when there is no trade risk, inside money is unnecessary. In Section 5, I weaken the perfect anonymity of the nonbank public by introducing the concept of credit lines, restricted to binary credit records.
I derive a necessary and sufficient condition under which credit is implementable.
I then find sufficient conditions under which inside-money allocations result in the banking sector intermediating capital. Section 6 concludes. All the proofs appear in the appendix.