Banking Panics and Deflation in Dynamic General Equilibrium

FEDS Working Paper No. 2015-018

http://dx.doi.org/10.17016/FEDS.2015.018

42 Pages Posted: 21 Apr 2015

See all articles by Francesca Carapella

Francesca Carapella

Board of Governors of the Federal Reserve System

Date Written: August 1, 2012

Abstract

This paper develops a framework to study the interaction between banking, price dynamics, and monetary policy. Deposit contracts are written in nominal terms: if prices unexpectedly fall, the real value of banks' existing obligations increases. Banks default, panics precipitate, economic activity declines. If banks default, aggregate demand for cash increases because financial intermediation provided by banks disappears. When money supply is unchanged, the price level drops, thereby providing incentives for banks to default. Active monetary policy prevents banks from failing and output from falling. Deposit insurance can achieve the same goal but amplifies business cycle fluctuations by inducing moral hazard.

Keywords: banking panics, deflation, deposit insurance

JEL Classification: E53, E58, G21, N12

Suggested Citation

Carapella, Francesca, Banking Panics and Deflation in Dynamic General Equilibrium (August 1, 2012). FEDS Working Paper No. 2015-018, http://dx.doi.org/10.17016/FEDS.2015.018, Available at SSRN: https://ssrn.com/abstract=2596720 or http://dx.doi.org/10.2139/ssrn.2596720

Francesca Carapella (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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