Banking Panics and Deflation in Dynamic General Equilibrium

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.