Working Paper

Financial Instability with Circulating Debt Claims and Endogenous Debt Limits

Abstract: This paper develops a banking model in which intermediaries issue liabilities that circulate as a medium of exchange to finance loans to entrepreneurs, who use the proceeds to fund the accumulation of capital goods. The issuance of circulating liabilities, together with endogenous debt limits, gives rise to a franchise value for intermediaries. A competitive equilibrium with endogenous debt limits admits allocations that are characterized by a funding crisis and a self-fulfilling collapse of the banking system, with the intermediary’s franchise value eroding over time. In view of these difficulties, I construct a sophisticated fiscal policy that provides a government guarantee for the franchise value, which results in the determinacy of equilibrium, with the constrained efficient allocation emerging as the unique outcome.

Keywords: circulating bank liabilities; endogenous debt limits; franchise value; funding crisis; government guarantees;

JEL Classification: E42; E44; G21;

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Bibliographic Information

Provider: Federal Reserve Bank of Philadelphia

Part of Series: Working Papers

Publication Date: 2020-11-24

Number: 20-45