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Money, Financial Stability and Efficiency

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  • Allen, Franklin
  • Carletti, Elena
  • Gale, Douglas M

Abstract

Most analyses of banking crises assume that banks use real contracts. However, in practice contracts are nominal and this is what is assumed here. We consider a standard banking model with aggregate return risk, aggregate liquidity risk and idiosyncratic liquidity shocks. We show that, with non-contingent nominal deposit contracts, the first-best efficient allocation can be achieved in a decentralized banking system. What is required is that the central bank accommodates the demands of the private sector for fiat money. Variations in the price level allow full sharing of aggregate risks. An interbank market allows the sharing of idiosyncratic liquidity risk. In contrast, idiosyncratic (bank-specific) return risks cannot be shared using monetary policy alone; real transfers are needed.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8553.

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Date of creation: Sep 2011
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Handle: RePEc:cpr:ceprdp:8553

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Keywords: monetary policy; nominal contracts;

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  1. Douglas W. Diamond & Raghuram G. Rajan, 2003. "Money in a Theory of Banking," NBER Working Papers 10070, National Bureau of Economic Research, Inc.
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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Money, Financial Stability and Efficiency
    by Christian Zimmermann in NEP-DGE blog on 2011-04-02 17:06:00
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Cited by:
  1. Allen, Franklin & Vayanos, Dimitri & Vives, Xavier, 2014. "Introduction to financial economics," Journal of Economic Theory, Elsevier, vol. 149(C), pages 1-14.

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