Fed in Print

Abstract

This paper develops a dynamic theory of money and banking that explains why banks need to hold an illiquid portfolio to provide socially optimal transaction and liquidity services, opening the door to the possibility of equilibrium banking panics. Following a widespread liquidation of banking assets in the event of a panic, the banking portfolio consistent with the optimal provision of transaction and liquidity services during normal times cannot be quickly reestablished, resulting in an unusual loss of wealth for all depositors. This negative wealth effect stemming from the liquid portion of the consumers' portfolio is strong enough to produce a protracted recession. A key element of the theory is the existence of a dynamic interaction between the ability of banks to offer transaction and liquidity services and the occurrence of panics.

JEL Classification:

E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

Fed-in-Print is the central catalog of publications within the Federal Reserve System. It is managed and hosted by the Economic Research Division, Federal Reserve Bank of St. Louis.

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