Working Paper

Banking Panics and Output Dynamics

Abstract: This paper develops a dynamic general equilibrium model with an essential role for an illiquid banking system to investigate output dynamics in the event of a banking crisis. In particular, it considers the ex-post efficient policy response to a banking crisis as part of the dynamic equilibrium analysis. It is shown that the trajectory of real output following a panic episode crucially depends on the cost of converting long-term assets into liquid funds. For small values of the liquidation cost, the recession associated with a banking panic is protracted as a result of the premature liquidation of a large fraction of productive banking assets to respond to a panic. For intermediate values, the recession is more severe but short-lived. For relatively large values, the contemporaneous decline in real output in the event of a panic is substantial but followed by a vigorous rebound in real activity above the long-run level.

Keywords: Banking panic; deposit contract; suspension of convertibility; time-consistent policies;

JEL Classification: E32; E42; G21;

Bibliographic Information

Provider: Federal Reserve Bank of Philadelphia

Part of Series: Working Papers

Publication Date: 2017-07-24

Number: 17-20

Pages: 54 pages